Operation Twist is a clever way for the Federal Reserve to stimulate the economy when interest rates are zero. Named after a dance craze from the 1960s, the Federal Reserve was inspired by the Chubby Checker hit “The Twist” that made Billboard records across the nation. When an economy is weak, central banks usually respond by lowering interest rates but when interest rates are already zero, further rate cuts are not an option. So what can a central bank do?

Lets first answer this question by looking at a normal yield curve, which slopes gently upward with longer-term bonds offering higher yields than shorter bonds.

Source: U.S. Treasury

When the Fed lowers interest rates, the yield curve gets pushed down as yields across all maturities decline. The following chart compares the yield curve in June 26, 2006, the most recent Fed rate hike with the first Fed rate cut in August 2007.

Source: U.S. Treasury

But when the Fed Funds rate and short term yields are already zero, the Fed has no additional room cut unless they want to interest rates to turn negative which means Americans would have to pay to put their money into banks.

So what can the Fed do? One option would be to drive down the right hand side of the yield curve. Long term interest rates still have room to fall. Even with the Federal Reserve’s massive amount of easing, 10 year bonds are still paying 1.64% while 30 year bonds pay 2.73% as of June 14th, 2012.

Under Operation Twist, the Federal Reserve raises money by selling shorter term bonds and uses that money to buy longer term bonds. Since bond prices and bond yields move in opposite directions, this in effective drives up short term yields and drives down longer term yields. The hope is that by attacking long term rates, the Fed will be focusing directly on the consumer since mortgages and businesses loans are usually tied to 10 to 30 year bond yields. They also hope that investors will buy stocks over bonds because of their unattractive yields.

There are no guarantees that Operation Twist will because a weak economy could deter Americans from buying new homes and businesses from borrowing for expansion.

Operation Twist was announced back in September and is set to expire at the end of June. On June 20th, the Federal Reserve will most likely extend the program for another 6 months. Here’s how the yield curve has changed since September.

Source: US Treasury

Video – Operation Twist Explained

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