The problems with Operation Twist

The US Federal Reserve has delivered another round of monetary stimulus, demonstrating its willingness to do even more to help America's fragile recovery.

But its central bank's decision to extend Operation Twist by $267 billion might not be enough.  While the move will see the Fed sell an equivalent amount of short-term debt to buy longer-term securities, which should keep long-term borrowing costs down, economists say that fresh stimulus will only be helpful at the margin.

'[It will] provide a very modest amount of stimulus to the economy,' said Kolychev Vladimir, of Societe Generale. 'By the Fed's own estimates, Operation Twist one compressed the yield on the 10-year treasury by about 20bps; extrapolating from that and allowing for some diminishing returns, [the] announcement is probably worth about 10bps, much of it already being priced in.'

Unlike quantitative easing, maturity extension used in Operation Twist does not generate portfolio balance effects, weakening its strength in terms of generating broad asset reflation. Since the Federal Reserve's balance sheet will not increase any further, there will also be no impact from last night's announcement via the forex channel.

Growth downgrade

Moreover, US central bankers used last night's announcement to unveil a more downbeat set of projections for growth, revising these to 1.9%-2.4%, down from the 2.4%-2.9% forecast released in April.

Earlier in the year quarter one growth rate figures came in at 2.2%, below the 2.5% expectation, and taking all these numbers into account, some strategists feel the market will have been hoping for much more from the Fed.

'In light of the forecast revisions, which were not trivial, many market participants were left wondering why the Fed chose such a modest response. During the press conference, chairman Bernanke noted that it is still not entirely clear how to read recent data, given the weather and seasonal distortions. However, he repeated on several occasions that the Fed is prepared to do more if further action is warranted,' said SocGen's economic analysis team.

So could the Fed follow up with a more aggressive response later this year?  It's possible, given last night's mixed message, but the sceptics expect Bernanke will avoid this step given he chose to expand the current Operation Twist programme by six months through to the end of the year, rather than running it over a shorter time frame.

Capital Economics is more positive on how nimble the Fed could be. Highlighting the accompanying statement with last night's announcement, the consultancy said Bernanke and the Federal Open Market Committee seems to appreciate the significance of tumbling growth on America's economic recovery.

It said: 'In the end, the Fed opted to extend its maturity extension programme (Operation Twist), but there was no new large-scale asset purchase programme (QE3). Nevertheless, the accompanying statement again warned that "strains in global financial markets continue to pose significant downside risks to the economic outlook. If those risks increase then we suspect the Fed would be pretty quick off the mark in taking more aggressive action.'