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Federal Reserve tries a tame 'Twist'

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.

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