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The Fed's big policy move: What it means

(MoneyWatch) The Federal Reserve concluded its last monetary policy meeting of 2012 with a bang. The central bank said it would allow "Operation Twist" to expire at year-end and replace it with monthly purchases of $45 billion of long-term Treasury bonds in order to keep long term interest rates low. Additionally, the Fed will begin using specific unemployment and inflation rate targets to guide future short-term interest rate policy.

Long-term interest rate policy: Since the financial crisis, the Fed has used the purchase of bonds ("Quantitative Easing" or "QE") in order to keep longer interest rates low. The idea behind QE is that the Fed buys U.S. Treasury bonds and mortgage-backed securities, which drives up prices, pushes down interest rates and reduces the availability of these bonds in the market. With fewer bonds available, investors turn to alternate assets, like corporate bonds. When the original QE was announced in March 2009, the economy was shrinking by an annualized rate of 5.3 percent and companies were having difficulty borrowing money. QE helped grease the wheels of corporate credit and helped the economy function more normally.

When QE2 was announced in 2010, corporate credit was not the issue, but a downshift in economic growth was worrying the Federal Reserve. The second round of QE was seen as a way to lower long-term rates, which would encourage more borrowing and spending, which would in turn (hopefully) create more economic growth. Operation Twist, which was implemented in September 2011, was a variation on QE. Each month, the Fed sold $45 billion worth of short-dated government bonds and bought an equal amount of government bonds with longer maturities. This fall, the Fed launched QE3, with an open-ended commitment to purchase $40 billion of mortgage-backed securities each month.

Operation Twist was set to expire at the end of this year and although the new policy has a similar goal and uses the same $45 billion target, there is a big difference: The new policy expands the Fed's balance sheet. As of last week, the Fed's portfolio was $2.861 trillion and now it will balloon until the central bankers believe the economy is on firmer footing and the labor market substantially improves. At that point, the Fed would sell the assets on the balance to remove liquidity from the system and hopefully prevent inflation from rearing its ugly head. Critics fear that the Fed will not be quick enough to sell assets and fight future inflation; and the sale of trillions dollars of bonds on the market would likely drive up interest rates and slow down the economic recovery.

Short-term interest rate policy: For nearly four years, the Fed has kept short-term interest rates at 0-0.25 percent and has said that rates would remain low until mid 2015. In today's announcement, the central bank has introduced a new communications strategy: It will use hard unemployment and inflation targets to help guide short-term interest rate policy.

Going forward, the Fed expects rates to remain very low as long as the unemployment rate remains above 6.5 percent and inflation "between one and two years ahead is projected to be no more than a half percentage point above the Committee's two percent longer-run goal, and longer-term inflation expectations continue to be well anchored."

While the change has been telegraphed by Fed governors recently (Fed Vice Chairman Janet Yellen recently called for specific thresholds to guide policy), this is the first time in the central bank's history that he conditions under which it expects to keep rates low. Whether these new thresholds will be more effective than the previous "date-based guidance" for policy remains to be seen.

Bottom line: The Fed continues to pull out all the stops to provide the economy with liquidity. But with demand and economic growth in low gear, it's not clear that the central bank has the tools necessary to boost growth.

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