Operation Twist 101


Given the confusion about Operation Twist, here’s an explanation.

What is Operation Twist? Basically the Fed can’t reduce short-term interest rates any further—they’re already at zero.  So they want to reduce long-term interest rates instead.  They do this by buying long-term bonds.  When you buy more of something, you raise the price.  And when you raise the price of a bond, you lower the interest rate.  So what the Fed is doing, is lowering long-term interest rates.

How does the Fed pay for these bonds?  With QE1 and QE2, the Fed effectively just printed the money.  (They “expanded their balanced sheet.”)  Instead, they are selling short-term bonds, and using the proceeds to buy the long-term bonds.  Now selling a bunch of short-term bonds will—usually—lower their price, raising short-term interest rates.  That’s why people call this “Operation Twist”—it should “twist” the yield curve—lowering long-term interest rates (which is what matters when you buy a house, or when a firm borrows to buy new machinery), but it also raises short-term interest rates.

Raising short-term interest rates is a bug, not a feature.  But fortunately, this time, the effect on short-term interest rates will be small.  Why?  The Fed has already committed to keeping short-term interest rates near zero for the next couple of years.  And so given this commitment, the 2-year bond will also be close to zero.

If you watched bond prices move yesterday, you would have seen that the short-term interest rates barely rose, while long-term rates fell a fair bit. So this wasn’t so much “Operation Twist” as simply the Fed reducing long-term interest rates.   In that respect, it’s a lot like QE1 and QE2.  The difference is that the size of the Fed’s balance sheet didn’t much change.

Why ease monetary policy in this new and different way?  Well, it has much the same effect as QE1 and QE2, but quiets many of the critics who were worried that by printing money, the Fed will spark inflation.  I think they’re wrong (and the markets agree with me), but the Fed seems determined to avoid being in the political cross-hairs.  Also, when the public hears about billions of dollars of quantitative easing, too often they misinterpret this as dollars building bridges we don’t need.  QE1 and QE2 didn’t do that.  But Operation Twist is clearer still: The Fed is just swapping one set of bonds for another.

Will it work? There are two levels at which we talk about these things working:

A.     Will the Fed succeed at reducing long-term interest rates?  They already have.  Despite the fact that Operation Twist was largely anticipated, this boost was larger than most expected.  And so in the minutes after the announcement, the 30-year Treasury fell by 13 basis points.  That might not sound like a lot (one-eighth of a percentage point), but it’s one-eighth off, for 30 years!  Those are some big savings.  Also, it’s worth comparing this with how much of a conventional reduction in short-term interest rates would be required to get the 30-year Treasury to fall this far.  The answer is: Quite a lot!

B.     Will this stimulate the economy?  Answer: It won’t hurt.  My own view is that the economy needs all the help it can get right now.  This is a step in the right direction.  I think that an economy this unhealthy needs even more medicine.  So I’m glad that the Fed took this step.  I’m not hoping for miracles, but it will help.

As for the next move for the Fed, I fear that the data for September are looking weak.  And most people are now expecting growth over the next year or two to be insufficient to reduce unemployment by much (if at all).  The Fed is more optimistic.  I think they’ll see more weak data coming, and so will have to move to even more accommodative monetary policy.  Watch for this to be controversial.  I don’t think it should be, but I think the Fed is doing a dreadful job in explaining that what it is doing is much more like conventional monetary policy than they are letting on.

My favorite policy suggestion right now comes from Chicago Fed President, Charlie Evans.  He has suggested that the Fed announce that they are willing to tolerate higher inflation until the unemployment rate falls below some level.  Why not make it clear: We want unemployment to fall below 7%, and we aren’t going to fret if pursuing that goal causes inflation to temporarily rise to say, 4%?  I know not everyone will like this, but the suffering caused by today’s unemployment is surely larger than that caused by a little inflation.  Indeed, many economists believe that a little bit of inflation would help consumers work their way out of their current debt overhang.


Why should be believe that a rise in inflation will cause a decrease in unemployment? Why should we re-visit the efficacy of the Phillips curve?

You are asking the Fed to decrease real wages by 2% on the HOPE that the Phillips curve will work and short-run employment will rise. But over the long-run, it's clear that employment and inflation have virtually no correlation. You cannot cause employment by inflating the currency... So your proposal seems like a bad bet to me.

Abe Froman - The Sausage King of Chicago


The Feds uses a bs inflation number anyways, so its probably not going to matter much. You say it would decrease wage by 2%, but is inflation really only 2% right now? The Fed numbers don't include food costs, and gas prices. Well gas is around $4 bux a gallon and box of cereal is $4 bux compared to like low $2s for both like 6 years ago. I'd say real inflation rate has increased quite dramatically, and is already affecting real wage by quite a bit.


Everything always sounds so rosy when the central planners pull their strings. Perhaps you could include a frank discussion of potential unintended consequences of yet another market intervention?

Let's start with banks, who make money borrowing short term and lending long term. Raising short term rates and lowering long term rates cuts their margins. You may have noticed bank stocks tanking when the policy was announced.

Their balance sheets are already a shambles with lord-knows what manner of non-marked-to-market assets. The fed has now cut deeply into their potential revenue sources. When we have the inevitable banking crisis in the next year, I hope anyone advocating this plan has the decency to admit their mistake, insofar as this twist layers on another dose of unintended consequences.

Sal M.

When you wrote:

Now selling a bunch of short-term bonds will—usually—lower their price, raising long-term interest rates.

did you mean:

Now selling a bunch of short-term bonds will—usually—lower their price, raising short-term interest rates.


- Sal M.


"The Fed has already committed to keeping short-term interest rates near zero for the next couple of years. "

So, how exactly is the Fed going to accomplish this? Just saying it doesn't make it so. That's not how the world or markets work. QE3 (or whatever they decide to call it) here we come.


They control the interest rates.....all the fed has to do to keep short term near 0 is do nothing. don't raise the interest rates.


Wolfers certainly takes a clearly one-sided look at things. I love Freakonomics.

Wolfernomics, not so much.

John B

Interest rates are not the problem. They are incredibly low on a historic basis.

If a business can't make money at very low rates, it won't make money at slightly lower rates.

If a person can't make mortgage payments at 5%, they won't be able to make them at 4%.

If this is all that the fed has left, we are in real trouble.


Sooner or later the Fed will realize this won't work, they will keep monetizing the debt, with so much money printing the Wiemar republic will look like nothing... better start hoarding beans and ammo, and maybe a few kiloTons of Gold.


Except the FED has no ability to create NET new money therefore can not "monetize" the debt. Although you can't monetize money in a fiat economy anyway...

The only way to create net new money is through deficit spending and the FED has no control over that.


The Fed not sparking inflation due to their printing money depends on how inflation is defined. The fear of the Fed printing money causing inflation is based upon the idea that more money will be in circulation facing an unchanged pool of goods and prices will trend upwards at a pace proportional to the excess supply. You state that the markets "agree" with you, and you take as proof the fact that bond prices have not risen as they would were continuing inflation feared. Despite the unchanged bond yields, price inflation, especially in food is quite evident. What gives?

The truth is that it isn't that the Fed dumped dollars into the economy, it is *how* they did it. The Fed purchased Treasury Bonds from the large investment banks like Goldman Sachs. In driving up the price and the yields down the Fed has made fixed income investments decidedly unattractive from a return standpoint. As a result, the money available following the sale of the bonds had to move into other assets classes, of which only three others exist: real estate, equities and commodities. The real estate market is still declining and unworthy of investment so the money looking for return went into equities and commodities. As a result, the S&P 500 more than doubled from its March '09 lows and commodities like cotton have seen a rapid "step up" in pricing as money moved from Treasuries. These moves are not based on consumer demand however, and are being artificially propped up by the money not being invested in bonds.

This is Bernanke's true fear: if interest rates rise money will come back out of these asset classes and pricing will collapse, sparking deflation and an instantaneous Depression as money flow comes to a grinding halt.


Alan T.

Why aren't more economists recommending somewhat higher inflation?

Inflation makes it possible to stimulate the economy during recessions by reducing interest rates. Inflation gives people and corporations an incentive to save and invest rather than to hoard money. And, as you point out, inflation reduces the real debt burden.


There are two problems with inflation, only one of which is generally recognized. 1) Inflation rewards consumption and penalizes saving. 2) Inflation misdirects the economy into overproducing for a false demand that must be compensated for later to purge excess inventory. In other words, as the inflationary "stimulus" ends, production falls off more sharply than if the stimulus had not been applied in the first place, thus causing a harsher landing than necessary. Thus inflationary stimulus is addictive.

In the long run, persistent bouts of inflation slow the economy.

Mike T

The underlying cause of long term unemployment cannot be addressed by any of the Fed's measures. The continuing practice of having 4 employees do the job of 5 people effectively keeps the need for hiring at low levels. Unfortunately or fortunately, depending on your perspective, some of these people will die on the job from the added stress and long hours provoking a small increase in hiring. The really bad news is that this will ultimately bring back unions, in the form of 'e-unions' reinventing the old tactics for controlling corporate greed and doing away with the idea of an 'exempt employee'. The cycle then reverts back to a non-competitive standoff in which the e-union cost, while more reasonable than it predecessors will still create uncompetitive products in the world markets. People do not learn from history, business specific history. Unions are old news, and quite antiquated in current society...yet the underlying need is manifesting itself again. Accountants...take note.



Is there not a flaw in a system that "when you buy more of something, you raise the price" and this is considered reasonable when talking about Fed/market policy? How do rational, intelligent people consider this smart policy when it goes against logic? It is the opposite of a normal market that is based on sound (sustainable) money and not an inflated monopoly system!
Furthermore, "I think that an economy this unhealthy needs even more medicine. So I’m glad that the Fed took this step." So, is that like treating cancer with poison to kill it? Instead of actually looking for the cause and effect and changing the policies that got us into this mess. I don't know, maybe promote ideas and policies that create a healthier, environmentally sustainable society rather than a destructive unsustainable environmental and monitary policy that promotes healthy corporate, bank and political society? Screw the sheeple and those in underdeveloped (non-Central Banking countries).
I used to think that you took the so called realities of the world and uncovered the real truth using sound logic, questions and unbiased economic reasoning to uncover the true basis of proplems and not just the perceptions. Why don't you use your own methadology next time instead of your opinions like those that you normally de-bunk! We've lived in this utopian monetary system created by thieves using the Fed to corupt governments for almost 100 years. We have all prospered as a result more or less for almost 100 years. Now the gig is up! It's time to face reality and live in the real world (natures law) before we allow the powers to be to destroy it for future generations!



Crazy, crazy, crazy! Be grateful with the easing we've had and swear off the 'stuff' for good. It's not "medicine" it's 90 proof snake oil. That and the euro crisis have bought us a few months more, a year or two at most. Right now Bernanke needs to be making clear to Congress that they owe him a big one for saving their sorry asses and he can't keep doing it. There is a point of diminishing returns beyond which it becomes totally ineffective, even counterproductive. It takes a while for the true inflationary effects of QE 1 & 2 to take effect, so don't start patting yourself on the back that we're out of the woods on that score. Not once has any paper currency ever worked itself back from the brink of hyperinflation once the total debt in the economy goes too far. Congress doesn't yet "get it".

Jaklyn Hutchins

This is all hopeless Supply Side Economics. Keynesians know what has actually worked in history:

no one wants to build a home or buy a new one if they are not sure they will keep or want to keep their current job(s), therefore it doesn't matter how low the mortgage rate goes as long as this insecurity reigns.

Supply Siders say "if you make it they will come (buy)". Keynesians know that "they" must have money to buy "it" first. It would be a better use of fed money, to give the 2 trillion est. of the new QE3 out in stipends to the poor and middle class. They will spend the money, creating demand for products, and businesses will begin or speed up production to meet this demand. The businesses will then hire people to create their products, and the economic cycle will begin. Supply Siders have it all backwards. Purposefully, of course. The princes see the rest of us as only serfs existing to service them.


Nick Georgalis

The reason that inflation has not emerged in any meaningful way is because the rate of productivity growth is currently exceeding the rate of the underlying inflation. The introduction of the computer, internet and cell phone into the workplace has enabled companies to do more with less people. Up until the financial fiasco of 2008, companies were able to maintain earnings without resorting to layoffs because revenues were growing and the GDP was increasing. After the financial markets crashed investment dried up and the layoffs began. The Fed then started printing money to prop up the stock market. This raised the value of equities while the GDP barely moved or went negative. This meant that companies were reporting little revenue growth. With no revenue growth and upward pressure on P/E companies had no choice but to seek ways to increase the rate of productivity growth to increase earnings. The low interest rates also helped by making it cost effective for companies to invest in mechanization of operations. These investment and the aforementioned technologies led to rapid improvements in productivity and more layoffs since revenue was stagnant or barely growing. In this way companies were able to increase earnings to sustain their elevated valuations. And in this way price increases were subdued so inflation has not been as big a problem as people originally thought. But the price paid so far is 37% of the able-bodied workforce unemployed, a GDP that is barely moving, and a 10% decline in median income. In other words the more money the Fed prints the more people that get laid off. However the party is nearly over because asset valuations are going higher as the Fed continues printing money and the rate of productivity growth has slowed as the number of unemployment claims has pretty much flattened. Combine this with higher corporate taxes and stifling regulations, which will further slow productivity growth, and companies will have no choice but to start increasing prices. This is when inflation will take off. The real danger however is the low interest rates. At long term rates below 2% the number of years that it takes for the principle to double rises asymptotically. This means that small increases in the interest rate at these levels results in large loses on the principle. There is currently over $5 trillion of US debt held by foreigners including the Chinese and Japanese. When productivity slows as it will and inflation starts to climb then interest rates will follow quickly. The Chinese and especially the Japanese will not want to lose principle and they as well as others will quickly dump their treasuries. This will accelerate the rise in interest rates and draw money out of the equity market at a very fast pace. Thus will the market crash, investment will dry up, unempl0yment will soar, civil unrest will ensue, and the piper will be paid.