By buying longer-term bonds, the Fed will cause price of those bonds to go up, and this will drive the longer-term yields down. Selling shorter-term bonds (to fund the purchase of the longer-term bonds) will put pressure on the price of the shorter term bonds, while driving short term yields up.
According to Bloomberg, “the Fed may decide at its Sept. 20-21 meeting to replace short-term Treasury securities in its $1.65 trillion portfolio with long-term bonds in a bid to lower rates on everything from mortgages to car loans... The Fed’s influence on the economy will probably be muted as sagging consumer confidence, depressed home values and 6 million workers unemployed for six months or more weigh on demand.”
Theoretically, driving down longer-term interest rates should help boost the housing market and consumer spending. However, this is another top down approach, and many doubt it would significantly effect the economy. As John Silvia, chief economist at Wells Fargo, noted, “The problem is that rates have been low for three years now and that isn’t spurring people to buy. Companies won’t hire unless demand is there. The Fed can lower the cost of credit, but it can’t force companies to create jobs.” (Next Stimulus May Do Little to Help Jobless)
"Dr Bernanke 'has no real policy options left that he did not use already last year and that with hindsight had no discernable economic impact,' Mr Walters [JP Morgan Australia and New Zealand economist] says. The stimulus did have a financial – as opposed to an economic – impact and one of those was to drive up the value of other currencies, the New Zealand dollar being one of them. Instead, there is a growing expectation the Fed will perform an updated version of Operation Twist, a move first performed in the early 1960s and named after a dance craze of the time.
Under that move, which ran between 1961-65, the Fed bought up long-term US Treasury bonds and sold short term bills, in a bid to flatten the yield curve, and thus help the housing market, but to do so in “sterilised” way that did not expand the money supply.
The move was widely regarded to have failed at the time, although recent academic work suggests it was more effective than was realised. (Financial markets: QE3 or Operation Twist?)
But Operation Twist is not a money printing campaign. Describing details about how Operation Twist will work, Emily Flitter suggests it would take some "fancy footwork" and the New York Fed would probably have to hold two auctions in a single day. The Fed would sell shorter-dated securities in a first auction, and then hold another auction to buy bonds with longer maturities. These auctions would both settle the following day.
While it would lower rates at the back end of the yield curve, Operation Twist could also nudge front-end rates higher, possibly to the benefit of money market funds scrambling for ultra-safe securities with a yield above zero.
"The way we looked at it, it looks like they could sell something like $265 billion -- everything they hold through June 30, 2013 -- and that could be absorbed with very modest rate movement," said Thomas Simons, money market economist at Jefferies & Co in New York.
"It might push rates a few basis points higher" in shorter-dated Treasuries, he added.
Goldman's Hatzius said such an operation would ultimately remove so much longer-dated debt from the market, its effect would be almost as big as the Fed's last major easing program. (Market expects Operation Twist in September)
Cullen Roche, at Pragmatic Capitalism, is concerned that more QE, even in the form of a twist, if open-ended, will cause more inflation. He concluded,
"open ended purchases are dangerous in this environment as it could fuel further surges in commodity prices leading to even higher cost push inflation as we saw during QE2. Misunderstanding leads to disequilibrium leads to increased economic turmoil (sound familiar?). This does not help the broader economy and in fact only further pressures the private sector. Pinning long-term rates will “work” in that it will suppress long rates, but I am doubtful that the Fed will do this and I am even more skeptical that it will have a substantive impact on the broader economy. Instead, my fear is that QE^n of this sort will merely induce further cost push inflation which will actually hurt the broader economy by offsetting any positive impact. The refinancing effect via lower long-term rates will certainly ease debt burdens on some households, but I am not optimistic that it will offset the potential risk of surging commodity prices (the refinancing effect is very focused while the commodity effect is broad across the entire economic spectrum)." (OPERATION TWIST – QE3 STYLE)
According to Bill Gross and Mohamed A. El-Erian at PIMCO, more stimulus from the Fed might have an adverse effect on the economy by driving up commodity prices.
“The balance between the benefits and cost and risks has changed in an adverse manner,” El-Erian said. “At the end of the day we will not be solving anything. We’ll just be undermining the economy and a critical institution for the well being for America.”
Governments should be focusing on creating growth rather than reducing debt, Gross said. “To do it right now is almost suicidal,” he said. (Gross Says Operation Twist Likely From Fed: Tom Keene)
Stock World Weekly editor Ilene asked Lee Adler of the Wall Street Examiner: “What makes "Operation Twist" a QE that will presumably help the economy?”
Lee responded (see also If Fed Twists, It Won’t Be Like It Did Last Summer):
“My understanding of the Twist is that the Fed would sell its shorter term Treasuries back to the Primary Dealers and buy an equal amount of longer term Treasuries from them. I guess the theory is that by pushing longer term rates even lower than they are now, this will magically transform the US economy into a growth dynamo. They apparently haven’t noticed that long term rates have been collapsing and that this has been accompanied by a weakening economy. They also haven’t noticed that Japan has tried variations of this theme for 15-16 years. Lots of good it did Japan.
“You are correct (in questioning how this will help the economy.) This is in no way a QE if the Fed simply holds its balance sheet flat. It would still be a net negative for the markets without actual SOMA [System Open Market Account] expansion. It’s a mean, stupid, and futile gesture (with apologies to Animal House) for an economy locked in a liquidity trap, and it could be a net negative for the banking system if it were successful in reducing long term yields (which I doubt it would be).” (Excerpt from Lee's Wall Street Examiner Professional Edition Treasury update.)
Whether the Fed begins another round of quantitative easing (QE3) or deploys another form of intervention (such as 'Operation Twist V2.0') the likely reality is that the Fed has no genuinely viable options remaining to help it achieve its dual mandate of maximum employment and stable prices, as established by the Federal Reserve Act. Instead, the Fed has been reduced to promoting politically expedient "solutions" in the face of a moribund global economy suffering from persistent and intractable unemployment.