Normally, the Federal Reserve aims to achieve its objectives by controlling the rate at which banks lend to each other overnight. This is called the Fed Funds rate. They do this through verbal intervention (stating what they want the rate to be) and by buying and selling short term treasury securities. Prior to starting Quantitative Easing (QE1), the Fed lowered the Fed funds target to a range of 0.0% – 0.25%. To maintain this target, the Fed bought short-term treasuries, which increased the supply of money looking for a temporary “home” putting downward pressure on the Fed Funds Rate. (Need a longer explanation of traditional monetary policy? Go here.)
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Its when the Fed uses a specified “quantity” of money to expand the range of securities it will buy, instead of focusing purely on short term securities to influence the fed funds rate. The range of securities includes treasuries with longer maturities as well as other instruments that the Fed is not traditionally involved in such as Mortgage Backed Securities.
To enact normal monetary policy and lower interest rates the Fed will buy short term treasuries which mature quickly, turning into cash from the Treasury. To enact QE, the Fed is buying longer term securities. Technically they could sell these longer term securities at anytime, however this would defeat the purpose of QE. As a result these these securities expand the Fed’s balance sheet dramatically and represent a long term increase in the money supply.
Why the differences?
While both QE1 and QE2 were about stimulating the economy and trying to avoid a deep recession, QE1 had another goal as well. After the financial crisis there was a lack of trust among the participants in the credit markets and specifically in the market for Mortgage Backed Securities. As a result the Fed felt that the market was in danger of freezing up if they did not intervene. This is why the Fed targeted that market specifically because in addition to any stimulus affect it had on the economy, they felt that it would stabilize the market.
Operation twist is the Fed selling short term treasuries that they hold and then using the money from those sales to purchase longer term securities. As the Fed is selling short term securities adding to their supply on the market, this should cause short term interest rates to rise. As they are buying longer term securities with that money this should cause long term interest rates to fall. The word “twist” comes from the fact that taking short term rates up and long term rates down “twists” the yield curve. It also comes from the fact that the first time this was tried was in 1961 when Chubby Checkers record “The Twist” had recently been #1 on the record charts.
In the more recent operation twist since the financial crisis, there has been so much demand from worried investors parking their money in short term treasuries, that short term rates have not risen noticeably as a result of the Fed’s selling of short term maturities.
Quantitative Easing is an outright purchase with new money that is created by the fed, so it is an injection of new money into the economy that was not there before. New money is not created with operation twist, as the proceeds from the sale of the short term treasuries are used to buy the longer term treasuries. This makes operation twist less potent than quantitative easing but it also reduces the risk that the Fed will “overshoot” and cause inflation to rise above a level that they are comfortable.
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