Updated

4 p.m.

The Federal Reserve’s latest move to help jump-start the economy has a twist: It won’t do much to help consumers, borrowers or the housing market.

The Fed will go on a bond-buying spree — again — in an attempt to drive long-term interest rates lower than they already are. The much-anticipated plan, dubbed Operation Twist by observers, should help push rates lower, boost the housing market, make it easier for consumers and business owners to borrow and help create jobs. That’s the Fed’s theory and intention.

But analysts say Operation Twist barely makes a dent in the problem.

“I fear it won’t have that much of an effect,” says Nigel Gault, chief U.S. economist at IHS Global Insight. “There is plenty of liquidity out there already, and interest rates are already extremely low. … Rates have not been an obstacle to growth.”

After a two-day meeting, the Federal Open Market Committee announced it will sell short-term Treasury bonds and reinvest about $400 billion in long-term Treasury bonds by the end of June 2012. It will sell Treasuries maturing in three years or less to buy Treasuries maturing in six to 30 years.

“This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative,” the Fed says in its statement. “The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.”

Operation Twist differs from QE1 and QE2, the two quantitative easing programs the Fed previously implemented, because it will not require the Fed to print new money to fund the bond purchases. With Operation Twist, the Fed will simply shift its investments around rather than increase the balance of its portfolio.

Will lower rates save the economy?

Mortgage rates have been at their lowest levels in six decades, but millions of homeowners can’t refinance at the lower rates because they don’t have enough equity in their homes. Many potential buyers, who would like to take advantage of the low rates, don’t qualify for loans or are afraid to commit to a mortgage in a shaky economy.

The Fed said it will try to keep mortgage rates low by reinvesting in mortgage-backed securities as mortgages are paid off and as Fannie Mae and Freddie Mac repay debts they owe to the Fed.

“It’s going to have a very marginal impact” Gault says. “It will keep mortgage rates steady. It might even reduce them a little bit but not much.”

Even if lower rates were the answer to dragging the economy out of the hole, Operation Twist still wouldn’t be enough to get the job done because its impact on long-term rates will be limited, analysts say.

“It would perhaps lower the 10-year rate by around 10 basis points,” says Dean Baker, co-director of the Center for Economic and Policy Research in Washington, D.C. “This will be passed on in mortgage rates and other longer-term loans. A 10 basis point reduction in rates would have a very limited effect — maybe boosting GDP by 0.1 or 0.2 percentage points at most.”

Given the severity of the current crisis and the high unemployment rate, the United States needs the gross domestic product to grow at about a 5 percent to 6 percent pace, Baker says.”But that does not seem to be in the cards,” he says.

Gault says he doesn’t expect long-term rates to fall more than 10 to 20 basis points. Others think rates may remain stable despite the Fed’s newly announced policy.

“Mortgage rates should remain stable and close to current levels,” says Brett Sinnott, director of secondary marketing at CMG in San Ramon, Calif. “Most of the market has this built in, so the reaction should be fairly subtle, and I would not expect it to last more than a day or two before we are onto the next piece of news.”

So why did the Fed go with Operation Twist?

With so much doubt surrounding the effectiveness of Operation Twist, you may wonder why the Fed chose this maneuver. Simply put, it’s because the Fed had to intervene to show investors that it has not lost control of the nation’s economic situation.

“I think it’s really a question of — they want to help, they would like to stimulate growth, but they have limited options with limited effects,” Gault says. “So rather than sitting there and saying ‘we’ve done everything we can,’ they are trying to move us a little bit in the right direction.”

And among the few tools the Fed had in the shed, Operation Twist was the least controversial one.

Operation Twist met the least resistance among Fed members mostly because it differs from QE1 and QE2, the two quantitative easing programs the Fed previously implemented. Operation Twist will not require the Fed to print new money to fund the bond purchases. With Operation Twist, the Fed will simply shift its investments around, rather than increase the balance of its portfolio.

The Fed has more than doubled the size of its Treasury bond portfolio to about $1.65 trillion since the financial crisis started three years ago, and the Fed embarked on a bond-buying frenzy.

Any attempts to make that portfolio larger would encounter strong resistance by some Fed members and heavy criticism by market observers who say the latest round of quantitative easing, QE2, hurt more than helped the economy because it sparked inflation.

Operation Twist: better than nothing

With more than 14 million people out of work, the unemployment rate stuck at 9.1 percent and no signs of improvement in the labor market, the Fed felt the pressure to act. Rumor that Operation Twist would be announced after the FOMC meeting created huge expectations among investors. If the Fed didn’t announce Operation Twist or a plan that didn’t meet the market’s expectations, the economy would take another hit, industry observers say.

“The stock market would take it very badly,” Gault says.

Mortgage rates would likely have taken a hit as well.

“I think long-term rates, including mortgage rates, are at near-record lows today at least partially because investors have already moved in anticipation of the Fed announcing an Operation Twist,” says Michael Fratantoni, vice president of research at the Mortgage Bankers Association. If the Fed had not adopted Operation Twist, long-term rates could have increased, he says.

Updated

2:15 p.m.

The Federal Reserve danced to the investors’ tune and announced Operation Twist.

The Fed will again go on a bond-buying spree in an attempt to drive long-term interest rates lower than they already are. The theory is the lower rates will help boost the housing market, make it easier for consumers and business owners to borrow and help to create jobs.

But in practice, Operation Twist, named after a similar Fed program in 1960, may not have much of an impact on the economy, analysts say.

After a two-day meeting, the Federal Open Market Committee announced it will sell short-term Treasury bonds and reinvest about $400 billion in long-term Treasury bonds by the end of June 2012.

“This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative,” the Fed says in its statement. “The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.”

Operation Twist differs from QE1 and QE2, the two quantitative easing programs the Fed previously implemented, because it will not require the Fed to print new money to fund the bond purchases. With Operation Twist, the Fed will simply shift its investments around rather than increase the balance of its portfolio.

Also as expected, the committee kept the federal funds rate, which is the rate at which banks borrow from each other, between zero percent and 0.25 percent. The committee announced in its last meeting that it would keep that key interest rate at near zero until 2013.

The federal funds rate, also known as overnight rate, is important to consumers because it influences the prime rate, which is currently 3.25 percent, and other short-term rates. The prime rate, rates on home equity lines of credit and variable-rate credit cards will remain unchanged.

Longer-term interest rates, including mortgage rates, could potentially fall 10 to 20 basis points as a result of the Fed’s announcement, some experts say.

Fed day coverage

Sept. 20-21, 2011

The sovereign debt crisis in Europe continues to rattle the globe, while at the same time the U.S. economy is beset by prolonged high unemployment, a tumultuous stock market and renewed recession fears.

In the center of it all the Federal Open Market Committee is meeting for two days this week — Tuesday and Wednesday — to determine the direction of monetary policy. The meeting was originally scheduled for one day only.

This particular FOMC meeting may turn out to be more fateful than most — or it may not. The world is waiting for more stimulus action from the central bank, and the question for many people is not if; it’s when.

Historical perspective

Last November, the Fed embarked on a $600 billion bond-buying spree, which lasted through June, known colloquially as QE2. Just two years before, in November 2008, the first quantitative easing program began, which would ultimately lead to the purchase of $1.25 trillion in mortgage-backed securities, $200 billion in government-sponsored enterprise bonds and $300 billion in Treasury securities.

Through this past summer as the economy sagged and the stock market sputtered, investors and Fed watchers wondered if the central bank would reprise its role of last year as the rescuer of markets and economy stimulator.

That is a role Fed Chairman Ben Bernanke subtly rejected in his speech in Jackson Hole, Wyo., in August.

“The Fed can’t do everything,” says Ernie Patrikis, partner at the White and Case law firm in the bank and insurance regulatory practice, formerly with the New York Federal Reserve and an alternate member of the FOMC.

“That was what Bernanke said in the speech out West. It is fiscal policy (from Congress) that needs to pick up; you don’t want the Fed to use every arrow in its quiver,” he says.

Nonetheless, expectations run high for some sort of added stimulus from the central bank.

An added twist

The central bank has several options when it comes to an additional stimulus, though any decision might be pushed off until the November meeting.

“I think some additional measure is inevitable, and the odds favor the September meeting,” says Greg McBride, CFA, senior financial analyst at Bankrate.com.

But waiting until the November meeting of the FOMC would give them a chance to look at another cycle of economic data, which might satisfy the committee’s inflation hawks.

Whenever the rate-setting committee does swing into action, the most likely course is known as Operation Twist.

Essentially this would entail using the proceeds from maturing short-term securities, which the Fed already owns, to buy long-term securities.

“By doing that, the Fed’s balance sheet stays the same size, but you change the composition, so that is why it is called the Twist — you’re reducing the holdings of short-term securities and increasing the holdings of long-term securities,” says Gregory Daco, principal economist in the U.S. macroeconomics group at IHS Global Insight, a research firm.

“The objective of such an action would be to lower or put downward pressure on long-term rates — so the 10-year Treasury yield might fall but also the conventional mortgage rates. That would help homeowners that are underwater right now,” he says.

Unfortunately no one knows how well lengthening the maturity of the Fed’s portfolio will work when it comes to tamping down long-term interest rates. As it is, rates are extremely low.

“I’m skeptical as to whether or not that is really going to do anything,” McBride says.

“Taking the proceeds of maturing shorter-term securities and putting that into the longer-term securities will further squeeze banks’ net interest margins, and for savers that means it will push yields even lower,” he says.

In normal economic times, when the Fed lowers interest rates, banks respond by lowering the rate they pay on deposits in order to make up for the loss of income from loans. When short-term interest rates fall, the cost of borrowing falls as well.

But banks may be close to a wall when it comes to lowering CD and savings account rates. In the most recent weekly rate survey by Bankrate, the average one-year CD yield stood at 0.39 percent, and the average money market account yield has been a whopping 0.15 percent for weeks.

“People aren’t buying homes because they don’t have confidence in their job security or financial stability. It’s not that they think rates are too darn high,” McBride says.

Other stimulus options available to the central bank include reducing the interest rate paid on the excess reserves banks park at the Fed; explicitly stating how long the balance sheet will remain at its current size or even expanding the balance sheet with additional bond purchases.

Dissension in the ranks

Daco also believes the central bank will take further action, but he predicts any new plans will be unveiled at the November meeting.

“They might offer a little bit further feedback into what option would be the best, but I don’t think they will take any decision at this meeting because there are still dissenting members,” he says.

At the August meeting, the FOMC chose unprecedented specificity, stating they will keep the federal funds rate exceptionally low at least through mid-2013.

Three out of the 10 voting FOMC members cast dissenting votes against that action.

There are generally 12 voting members of the committee, but two seats have yet to be filled.

In the intervening weeks since that meeting, the three dissenting members, who are Federal Reserve regional presidents — Richard W. Fisher from Dallas, Narayana Kocherlakota from Minneapolis and Charles I. Plosser of the Philadelphia Federal Reserve — have gone on the record explaining why they disagreed with taking that step and why they may be waiting for more bad news before agreeing to further actions.

“Some of the reasons include the risk of being misunderstood in the direction that monetary policy is taking; the view that the monetary tool will not resolve the situation, and that the government needs to take steps to stimulate the economy in the short term and reduce balances in the long term,” says Daco.

“And also, inflation is now a bit higher than it was back in November. As a result, this did not warrant further monetary easing,” he says.

Secondary to what the Fed decides to do at the meeting this week, everyone will be watching for dissension in the ranks and how it impacts the actions taken by the committee.

Come back Wednesday after 2:15 p.m. EDT to find out what happened in the FOMC meeting.

Promoted Stories