The purpose of Operation Twist is to lower long-term Treasury yields, and therefore interest rates. It does this by increasing the demand of Treasury notes. As demand rises, so does the price, just like any other asset. However, higher bond prices are usually offset by a lower yield for investors. For more on how this works, see Treasury Yields.
How does this lower interest rates? The 10-year Treasury note yield is the benchmark for interest rates on all fixed-rate loans, including mortgages. The Fed uses Operation Twist to make loans more affordable, encouraging borrowers to purchase real estate, cars and furniture. This also allows businesses to expand more cheaply.
Operation Twist in 2011Federal Reserve Chairman Ben Bernanke announced the $400 billion Operation Twist program in September 2011. As Treasury short-term (3 years or less) bills and notes matured, the Fed would use the proceeds to buy longer-term (6-30 years) Treasury notes and bonds. The Fed would also buy new mortgage-backed securities (MBS) as the old ones became due. The Fed could also buy the long-term Treasuries with proceeds of MBS, if it felt necessary.
The twist showed that Bernanke was shifting the central bank's focus from repairing the damage from the subprime mortgage crisis to supporting lending in general. The Fed also announced it would keep the Fed funds rate at zero until 2015.
Through Operation Twist, the Fed was moving investors away from ultra-safe Treasuries into loans with more risk and return. Demand for Treasuries was still high, thanks to concerns over the eurozone debt crisis. By intentionally lowering yields, the Fed was forcing investors to consider other investments that would help the economy more.
The policy worked. In June 2012, the yield on the 10-year Treasury fell to 200-year lows. As a result, the housing market started to come back, as did bank lending. Other factors helped, but the Fed's leadership through Operation Twist was a consistent guiding light. It ended in December 2012, when QE4 was announced. For more, see Why Mortgage Rates Might Not Be This Low for Another 200 Years.
However, many criticized the Fed's actions. They said that, despite expansionary monetary policy, the economy wasn't growing. Unemployment remained high because businesses weren't growing and creating jobs.
Unfortunately, the Fed can only do so much. Bernanke warned several times that legislators needed to head off the fiscal cliff. Businesses remained cautious, despite the availability of cheap loans. The Fed chair basically said the Fed had the gas pedal to the floorboards, but couldn't overcome the uncertainty created by the fiscal policy stalemate. Why Operation Twist Won't Create Jobs.
Operation Twist in the 1960sThe original Operation Twist was launched in February 1961. It was named after a dance made popular by singer Chubby Checker. The Federal Reserve began selling its holdings of short-term Treasury bills, trying to raise yields. It wanted to encourage foreign investors to park their cash in these bills, instead of redeeming the cash for gold.
At the time, the U.S. was still on the gold standard. Foreigners who sold products in the U.S. would just exchange it for gold, thus depleting reserves in Fort Knox. Without gold reserves, the U.S. dollar was not as strong or powerful. As U.S. affluence grew after World War II, consumers imported more and more. Today, we no longer worry about the gold in Fort Knox because President Nixon abandoned the gold standard in the 1970s.
The Fed also wanted to boost lending by lowering yields on long-term Treasuries -- just like it does today. The economy was still recovering from the recession of 1958, itself brought on by the end of the Korean War.
Operation Twist was a bold Fed action. Fed Chair William McChesney Martin allowed himself to respond to President John F. Kennedy's request to buy long-term notes and lower the interest rate. Other Fed Board members were resistant to the "political influence." However, Operation Twist did work to boost the economy by raising short-term rates, although it wasn't aggressive enough to lower long-term rates. Nevertheless, the recession ended. (Source: Bloomberg, History Suggests Operation Twist Should Get More Airtime, December 12, 2012) Article updated 12/22/12.