Operation Twist, named for the twist of the Treasuries yield curve that it's supposed to cause, is a form of monetary policy in which the Fed alters the composition of the Treasury and mortgage bonds in its portfolio in order to push down yields. The Fed does this by selling short-term bonds and increasing the number of long-term bonds it holds, doing so through open market operations. The hope is that these actions will jumpstart the economy and lead to higher employment while keeping inflation in relative check - two of the Fed's mandated goals.
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Operation Twist may be a new term to many investors, but old timers and investors with a knack for history will remember that this is not the first time that the Fed has intervened in the markets in this fashion. In 1961 and 1962, the Fed deployed the strategy in an effort to push short-term rates up and long-term rates down in an attempt to guide the U.S. out of a recession. It wanted lower, long-term rates to increase long-term capital investment, since companies tend to plan investments over many years, and wanted higher short-term rates to attract foreign investors who would buy dollar-denominated investments and help reduce the U.S.'s balance of payments. The Fed would buy long-term instruments if it needed to increase its reserves or lower rates, and would sell when it needed to lower reserves. (The economy can be volatile when left to its own devices. Find out how the Fed smooths things out in The Fed's New Tools For Manipulating The Economy.)
The Fed of the 1960s took a much less policy-neutral approach than it would in later decades. It was taking an active approach in determining the direction of the economy by concentrating its efforts on one area of maturity. For the post-twist decades leading up to the latest rounds of quantitative easing, the Fed would focus on bills, notes and bonds with the intent of not heavily influencing rates. It would rarely liquidate its holdings. The Fed purchased nearly $4 billion worth of coupon securities from 1961 to 1962, with the lion's share being intermediate-term Treasury coupons with maturities of one to five years.
Did the strategy work? Growth in U.S. GDP did pick up in the early 1960s, averaging 5.68% growth year over year from 1962 to 1965. Gross private domestic investment, which includes purchases of equipment and other fixed assets, grew an average of 10.4% during the same period, with fixed investments growing 9.18% each year. To what extent Operation Twist was the catalyst in this change is debatable. Later analysis of the Fed's moves determined that changes in the term structure of the Fed's holdings did not substantially change the yield curve, and if changes were made they tended to be short-term. (Learn more in Bond Yield Curve Holds Predictive Powers.)
The Fed's recent foray into another round of Operation Twist involves purchasing bonds with distant maturities (from six to 30 years) and selling bonds with maturities at three years or less. This will increase the average maturity of the Fed's holdings as it picks up more long-term bonds. Unlike the Fed's previous attempts at boosting the economy through quantitative easing, which involved printing money, Operation Twist does not involve increasing the Fed's balance sheet and may have a smaller effect on inflation rates. Like the previous Operation Twist, this action directly involves the Fed in the outcome of the economy as a whole, and is certainly not a policy promoting laissez-faire and free market principles. Also, as with the previous iteration, not all members of the Federal Open Market Committee are on board with the policy (three of the 10 members dissented).
While some economists have estimated that the Fed's moves may reduce interest rates by tenths of a percent - a sizable effect when multiplied by the extent of borrowing - the speed of information and investor expectations may limit the Fed's success. By and large, the largest factors holding back growth are political and macroeconomic instability, especially in the face of Europe's woes. (For more, check out How Much Influence Does The Fed Have?)
The Bottom Line
What may be the biggest concern when it comes to the contemporary Fed is whether its policies are made independent from political pressures, or if, like the Fed of the 1960s, pressure to right the American economy was coming from political office. If investors start believing that the Federal Reserve is no longer able to operate independently and is not focused on the long-term - as politicians rarely are - then it will lose a substantial amount of its credibility.