Operation Twist - Probably misinterpreted

I know this post is challenging and is aimed at A2 students only. However it is a very important recent development in monetary policy.

The Federal Reserve has undertaken a restructuring of the debt it holds in an attempt to lower long term interest rates. This has become known as 'Operation Twist', but this is mainly because people want more.

The Fed has tried to lower long term interest rates by causing an excess of demand in the market for long term government debt. This is done by withdrawing from the market long term debt by buying it themselves. Such government debt is an important part of many investment funds portfolios, for example pension funds.

As a result there is less long dated government debt on the market and so the price of the remaining debt is bid up. A government bond pays the holder a fixed amount each year, say $2 for each $100 of the face value of the bond.

As the price of the government debt rises then the annual payment made by the government to the holder of a bond is a lower percentage of the market price. This means long term interest rates are lower. For example a $100 bond pays $2 a year. The market price of the bond is forced up t0 $200 and so the $2 paid now represents a rate of interest of just 1%.

So the Fed have tried to buy up long term bonds, taking them off the market, and replacing them with short term bonds. This will hopefully reduce the rates on all long term loans and so stimulate, for example, mortgage borrowing. This would encourage a recovery in the housing market which remains crucial in the USA.

The markets have taken this as a sign of panic. This has not helped confidence, hence the plunge in the stock markets. The markets also wanted more Quantitative Easing as they feel the economy needs a bigger boost.

I am far less clear on the Fed's motives. There was a time when central banks structured the debt in a way that was consistent with the interest rate set. Having more short term bonds on the market certainly increases the liquidity of the market and most commentators seemed to have missed this.

This is an unusual move by the Fed. It has been, at best, badly received and at worst seen as a sign that the policy options have run out. Most economists also doubt that the move will actually be effective.

The Guardian explains 'Operation Twist' here