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Fed Finale: The End of Operation Twist, or the Start of QE4?

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The Federal Reserve will hold its last policy meeting of the year next week, and two key issues are expected to dominate the gathering and the market's attention -- the expiration of "Operation Twist" and a potential change in interest rate guidelines.

Implemented in September 2011, Operation Twist was designed to lower rates for mortgages and corporate bonds. The program, which expires at the end of this month, entailed the Fed buying $667 billion (roughly $45 billion per month) in longer-term Treasuries above 6-year durations, while selling the same amount in shorter-term securities under 3-year durations.

The goal of the monetary twist has been to lower long-term rates to fuel consumer and corporate borrowing and spending.

"With Operation Twist ending, that means they've run out of short-dated securities to sell in order to purchase more [longer-term securities], so what they've got to move to now is buying up pure $40 billion per month of mortgage-backed securities [QE3]," says Andrew Wilkinson, chief economic strategist at Miller Tabak. "They probably have to compensate for that loss of $40 [billion] to $45 billion per month."

Rumors of QE4

Wilkinson is touching on concerns that have recently been addressed by various Fed governors. That is, that simply carrying out the third round of quantitative easing is not enough to boost the economy. QE3 is an open-ended program that has the Fed buying $40 billion per month in mortgage-backed securities.

So will the Fed turn Operation Twist into another outright securities purchasing program, essentially becoming QE4? Or are they more confident in the economy given the improvement in the November jobs report?

The market will be watching very closely to see if the Fed changes its tune. The decision on handling Twist's expiration will be very telling as to how the committee views the recovery and how much stimulus will be pumped into the economy in 2013.

FOMC Rate Policy: Debating Numerical Thresholds

"There's something else on the table with the Fed though," says Wilkinson. "They may move to targeting a specific rate of unemployment as a guarantee to when they can stand by the promise of low interest rates."

The Fed's current policy is to hold rates near zero through mid-2015. Chatter is growing louder that the Fed will change its guidelines, and instead of tying interest rate policy to a calendar date, they will link it toward set goals for the unemployment and inflation rates. This would directly link rates to the Fed's dual mandate to promote maximum employment and price stability.

Fed Vice Chairman Janet Yellen recently joined several other Fed officials calling for specific thresholds to guide policy. These thresholds would not be triggers to change policy, merely guidelines for debate.

"For now, it doesn't really matter," Wilkinson says of the possible shift. "As next year progresses we'll hear more in terms of jawboning from the Fed, how it's going to go about this process, how it's going to anchor its inflation expectations, and whether we should be focused on more than purely employment. Inflation is equally important, but there's a lid on it at around 2%, according to the Fed's projections. We also have to factor in GDP as well."

The Fed's gathering will end Wednesday with a 12:15 p.m. ET policy statement, and a press conference with Fed chief Ben Bernanke will follow a short time later.

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