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Fed's 'Operation Twist,' Explained In 4 Easy Steps

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Note: Robert Smith has an Operation Twist explainer on Wednesday's Morning Edition, complete with soundtrack. The story's attached above.

The interest rate on 10-year Treasuries is 1.95 percent. This is crazy low. It's lower than inflation. But the Federal Reserve may be about to push the rate even lower.

The Fed has at its disposal one key tool: interest rates. So when Fed officials are worried about unemployment, they try to drive down interest rates, in an effort to encourage people and businesses to borrow and spend.

And with unemployment over 9 percent (and core inflation at 2 percent), the Fed is likely to keep hammering away, trying to push down interest rates.

The Fed will announce its next move on Wednesday afternoon, at the close of a big, two-day meeting. That move is expected to be something known as "Operation Twist."

Here's what it means.

1. The Fed already owns more than $1 trillion in bonds, purchased over the past few years in an effort to bring down medium- and long-term interest rates.

2. A lot of those bonds — hundreds of billions of dollars worth — are medium-term bonds, which come due in the next few years.

3. Interest rates on medium-term government bonds are already near zero.

4. The Fed may sell some of those medium-term bonds, and use the proceeds to buy longer-term bonds — such as 10-year Treasuries.

Operation Twist should, in theory, drive down the interest rate on 10-year bonds. (When demand for bonds rises, interest rates fall.) Lots of other interest rates — including mortgages — are tied to the 10-year Treasury rate. So this should drive down interest rates across the board.

But it's unclear how much effect the effort will have at this point.

The term "Operation Twist" comes from the early 1960s, when the Fed tried something similar. It may have had a small effect — one recent study found that it drove down the interest rate on Treasury bonds by 0.15 percentage points. But the effect on mortgage rates was smaller, and the effect on corporate borrowing costs was tiny.

What's more, interest rates are already super low. And it's clear that the economy has lots of problems that lower interest rates alone can't solve. Fed officials know this, but there's not much they can do about it. All they can do is keep trying to lower interest rates.

Copyright 2011 National Public Radio. To see more, visit http://www.npr.org/.

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