QE1, 2, and Operation Twist: The Explanation to End all Others

July 27th, 2012 by

Quantitative Easing and Operation TwistNormally, 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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What Caused them to do something different after the financial crisis?

Two things:

  1. After the financial crisis the Fed had not achieved the desired effect on economic growth and employment despite taking the rate effectively to zero. They had basically “run out of ammunition” with this traditional policy tool.
  2. Credit markets, and specifically the market for Mortgage Backed Securities (MBS or the market where home loans are bought and sold by banks and other investors) were starting to freeze up.  There was a concern that if the Fed did not step in that buyers and sellers of these instruments would not transact at any price.

 

What is Quantitative Easing (QE) and How does it Differ from Traditional Monetary Policy?

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.

 

What is the Difference Between QE1 and QE2?

Two things:

  1. The “quantity” of money that was used in the programs.  In QE1 which started in late 2008 the Fed injected over $1.25 Trillion into the economy.  In QE2 which started in late 2010, the Fed injected $600 Billion into the economy.
  2. The types of assets the Fed Purchased.  In QE1 the Fed purchased primarily Mortgage Backed Securities which are pools of home loans which are packaged up and then bought and sold by investors in the market. In QE2 they purchased Treasury Securities similar to what they purchase through their normal operations, but with longer maturity dates (they were focused on influencing long term interest rates instead of just short term).

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.

 

What is Operation Twist?

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.

 

What’s the Difference Between Quantitative Easing and Operation Twist?

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.

Have a question about QE or operation twist that we didn’t answer?  Hit us up on the comments section below.

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