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Fed tries a new stimulus dance with ‘Operation Twist’ Add to ...

The Federal Reserve will deploy yet another largely untested stimulus measure, warning that the flagging U.S. economy faces “significant” threats that could derail an already tepid recovery.

Wall Street analysts call the latest move by the Fed a “twist.” Over the next nine months, the U.S. central bank will purchase $400-billion (U.S.) in U.S. government debt that comes due in six to 30 years. The central bank will raise the money by selling from its holdings of Treasury securities that mature in three years or less.

The strategy was last tried back in 1961, when it was dubbed “Operation Twist,” after the popular dance move. The moniker applies because policy makers are attempting to “twist” the natural trajectory of interest rates, or the yield curve, by closing the gap between interest rates paid on longer-dated securities and the interest paid on shorter-dated ones. The idea is to create an incentive for businesses to invest and hire by offering them a chance at cheap money for an extended period of time.

“This program should put downward pressure on longer-term interest rates and help make the broader financial conditions more accommodative,” the Fed’s policy-making said Wednesday at the end of a two-day meeting in Washington, citing high unemployment, weak household spending and a depressed housing market.

Ten-year Treasury yields dropped to a record low after the Fed’s announcement and 30-year bond rates dropped to the lowest since January, while the yield on two-year yields rose. At the same time, North American stocks tumbled and the U.S. dollar rose. The Canadian dollar sank below parity. Some analysts said the Fed’s worries about the economic outlook caused investors to shed risky assets and seek havens such as the U.S. currency.

Economists are mixed on whether the Fed’s latest strategy will do much to spark the economy, as interest rates already are exceptionally low, and some worry the Fed’s twist could even backfire.

That’s because banks make money by borrowing at the short end of the yield curve, using the money to lend at more lucrative rates over the longer term. By flattening the curve, the Fed risks crimping bank profits, creating a disincentive to lend. Insurance companies, such as Manulife Financial and MetLife, which use long-term bonds to back future obligations, also face a hit. Lower yields on that debt mean smaller profits.

But that’s a risk Fed chairman Ben Bernanke and the majority of his policy committee is willing to take.

Mr. Bernanke and his allies on the committee are pushing the bounds of monetary policy because the economy continues to struggle even though the Fed’s benchmark lending rate has been at nearly zero since December, 2008.

Twice the Fed has sought to lower borrowing rates by creating money to buy financial assets, a policy known as quantitative easing. In August, the central bank made a conditional pledge to keep its key rate exceptionally low until mid-2013, providing extraordinary clarity for a central bank.

And Wednesday, along with the twist move, policy makers said they would reinvest the proceeds from its holdings of housing-related securities back into mortgage-backed securities, a decision that could spur home lending by offering banks an opportunity to offload some of their risk on the Fed.

Policy makers are willing to take greater chances with policy because they are failing miserably to meet their congressional mandate to foster “maximum employment.” The Fed considers an unemployment rate of about 5.5 per cent to be consistent with that mandate. The unemployment rate currently is 9.1 per cent.

“The committee continues to expect some pickup in the pace of recovery over the coming quarters, but anticipates that the unemployment rate will decline only gradually,” the statement said. “Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.”

Mr. Bernanke and six others on the committee proceeded with the new measures over the objection of three committee members, an unusual level of dissent among a group that typically strives for consensus.

Dallas Fed president Richard Fisher, Minneapolis Fed president Narayana Kocherlakota and Philadelphia Fed president Charles Plosser voted against the decision, disagreeing that further stimulus was necessary at a time when the economy is growing, if only slowly.

By going ahead with “Operation Twist,” Mr. Bernanke also is courting political trouble. The top two Republicans in the Senate and the House of Representatives sent Mr. Bernanke a letter Monday, questioning the efficacy of the Fed’s previous efforts to stimulate the recovery and calling on him to “resist further extraordinary intervention in the U.S. economy.”

Politicians often criticize the Fed, but such an overt intervention during a meeting of the policy committee is rare, if not unprecedented. Democratic leaders harshly criticized the Republican missive as disrespectful of the central bank’s independence.

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