What To Expect From The Fed's 'Operation Twist'

Some semblance of calm returned to the financial markets today, but according to financial analysts, the jury is still out on the Federal Reserve's “Operation Twist,” designed to simulate the economy.

The market plunged Thursday after the Fed announced the plan – which consists of moving more of its portfolio to long-term instead of short-term bonds. The Fed statement that it saw “considerable downside risk to the economy” probably didn't help matters, as the Dow Jones Industrial Average suffered its largest two-day decline since 2008.

Jerry Webman, chief economist at OppenheimerFunds Inc. in New York, told Bloomberg News that the Fed has not done a very good job of explaining to investors how “Operation Twist” will help.

Not addressing the problem

Radhakrishnan Gopalan, PhD, assistant professor of finance at Washington University in St. Louis, doesn't believe the program will have much impact at all, because it is aimed at driving down loan term interest rates, which he says is not the problem.

“The problem is uncertainty and lack of demand, both domestic and export. So a few basis points fall in long-term rates may not have a big impact,” Gopalan said.

Operation Twist calls for the Fed to shuffle $400 billion of its portfolio from short-term bonds to long-term in an effort to keep long-term interest rates low. By July 2012, the Fed will buy Treasury bonds with maturities from six years to 30 years, while selling an equivalent amount of Treasuries with maturities of less than three years over that span.

Uncertainty

“The fact is, no one is complaining that long-term interest rates are too high and hence they are not investing,” Gopalan says. “People are not investing because of heightened uncertainty.”

Gopalan says long term rates are already low and firms lately have been taking advantage of that buy borrowing more. The problem, he says, is that they are stashing the money away in a “rainy day fund” or investing it outside the U.S.

Jim Paulson, of Wells Capital Management, told CNBC the Fed's pessimistic statement is responsible for this week's market sell-off. He says the U.S. economy is “on the mend” and that fears of another recession are overblown.