Due to the fact that this week’s workshop was on how the economy affects the financial world, I have taken the pleasure to write about a particular tool the FED uses to stimulate the economy: “Operation Twist”
Operation Twist is a policy used by the Federal Reserve to stimulate the economy without having to print money. According to Paddy Hirsch of Marketplace, the FED sells US short term government securities and uses the revenue generated to buy 10-year treasury notes. By buying the 10-year note it decreases the supply of 10-year notes available in the market, and as we know from the supply and demand theory a lower supply will lead to higher 10-year note prices. The catch is that as we know from bond pricing theory, which we learned on this week’s workshop, yields decline as prices increase.
So, why would the FED sell short-term treasury bills to buy 10-year treasury notes? The reason behind Operation Twist is that the yield on the 10-year note is used as the benchmark for many loans provided by financial institutions. For example, when you go and apply for a mortgage loan, the interest rate on that loan will most likely by based on the yield of the 10-year note. This applies also to car loans, and many other loans that have similar maturities. By decreasing yields on the 10-year note, interest rates on the latter loans mentioned also decrease making it cheaper for consumers to borrow.
According to Matt Nesto of Yahoo Finance the problem is that yields are already almost zero and demand is still not up. People don’t know if they will lose their job tomorrow, investors don’t know exactly what the repercussions of the sequester will be, and if operation twist doesn’t work to revamp the economy, we might see QE5. This brings back inflation risks, and it is also another way of kicking the can down the road by trying to push the economy into a path it doesn’t want to go…and this leaves us all needing a drink.
By: Luis Alfonzo Chacin
