It is no secret our economy is in hot water. Between foreclosures, personal debt burdens and the number of bankruptcy filings hitting all time highs, many Americans are left to wonder if things could get any worse. Despite the answer to that question being “of course,” we can find comfort in knowing that finding a solution to our economic troubles has taken priority in Washington.
The Federal Reserve is announcing a new stimulus plan this week aimed at relieving the economic turmoil. What is being dubbed “Operation Twist” is a plan that is derived from a popular card game.
In most games you have two options: (a) you can “stick”, in which you keep the hand you are holding or (b) you can “twist”, in which you draw another card to change the current hand. Up until a few weeks ago, the Federal Reserve was trying to “stick”, but has now decided it needs to “twist”.
How does it work?
In short, the Federal Reserve will sell short-dated bonds and buy long-dated bonds. A short-dated bond matures in one to two years; whereas, a long-dated bond could take up to 30 years to mature. The idea is to increase the demand for long-dated bonds by soaking up the supply. When the demand for the long-dated bonds exceeds the supply, the “yield” or effective rate of return lowers. A lower “yield” means lower interest rates for vital industries such as mortgages, car loans and personal loans.
Will it work?
Maybe. The Federal Reserve tried a similar tactic in 1961 and was successful in lowering the long-term interest rate by 0.15 of a percentage point. The drop in interest rate in 1961 was more of a big deal compared to today, as current interest rates are far lower today than in 1961. However, the efforts are likely to pay off in two ways (1) the lending industry should see an increase in applicants for loans and (2) consumer confidence should get a much needed boost, as they see the government doing their part.