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Q&A about the Fed's 'Operation Twist'

NEW YORK (WTW) — Q. What did the Federal Reserve say it would do?

A. The Fed on Wednesday announced a new effort to drive down long-term interest rates. The plan is to sell $400 billion in Treasurys coming due in the next few years and use the cash to buy Treasurys due between six to 30 years from now. The move is designed to nudge down long-term interest rates, already at record lows, and make it even cheaper for corporations and consumers to borrow.

Fed-watchers had expected the move and had a name ready: "Operation Twist." It's a nod to economic history and Chubby Checker. In 1961, the Kennedy administration cut long-term rates while leaving short-term rates alone. They dubbed the move Operation Twist, after the dance craze.

Q. How did markets react?

A. Stock indexes took a dive. The Standard & Poor's 500 index dropped 2.9 percent, its biggest loss since Aug. 18. The Dow Jones industrial average fell 2.5 percent. Commodities from crude oil to gold and copper dropped, usually a sign traders are betting on a weaker economy.

But the Fed couldn't have asked for a better response from the bond market. Long-term interest rates hit modern-era lows. The yield on the 10-year Treasury note, a benchmark for mortgages and corporate loans, sank to 1.85 percent. The 30-year Treasury dropped to 2.99 percent.

Q. Do investors think the Fed's move will help the economy?

A. Investors and market economists seem split between those who think Operation Twist will give economic growth a slight lift and those who think it will do next to nothing.

"I don't think it's going to help," said Michael Sansoterra, portfolio manager at Silvant Capital Management. "The issue is we need to spur jobs," he said. And encouraging corporations to hire workers is out of the Fed's hands.

What the country needs, many economists say, is government spending. The Fed has already tried two rounds of bond-buying. Each effort raised hopes that Fed would stimulate economic growth. Stock markets jumped in anticipation. Starting last year, the Fed bought $600 billion in Treasurys and helped launch a rally that sent stocks up 28 percent in eight months. But the economy grew a mere 0.7 percent the first half of the year.

The Fed is "running out of bullets," said Lawrence Creatura, a portfolio manager with Federated Investors. "And it's not because they haven't done a good job. But monetary policy only takes you so far. The true solutions no longer lie with the Fed. They lie with Washington."

Q. What's likely to happen now?

A. Investors don't expect much to change, because everybody saw the Fed's move coming. Economists estimated "Operation Twist" would knock roughly 0.2 percentage points off long-term interest rates. But much of that has already been priced into stocks, says Guy LeBas, fixed income strategist at Janney Montgomery Scott.

The Fed's actions may have even less of an impact on other markets, says David Kelly, chief market strategist at J.P. Morgan Funds.

Q. So investors don't think Operation Twist will do much good. Do they have any better ideas?

A. Kelly said the Fed should threaten to raise rates instead of promising to keep short-term rates near zero until the middle of 2013. Why? It would be an incentive to borrow and spend, he says. People looking to buy a house may rush to lock in current record low mortgage rates before they start rising. "Right now they have zero incentive," Kelly said.

Higher interest rates also drive down bond prices. So the threat of an interest rate hike would likely "kick people out of Treasurys," he said, and coerce them into the stocks or other investments.

"It's like a patient that's been in the sick bay too long," Kelly said. "The Fed really needs to tell the economy to get out of bed and walk around. Unfortunately, they keep giving it more and more doses of morphine."