The Federal Reserve is likely to expand the third installment of its open-ended quantitative easing program, under which the Fed is currently purchasing $40 billion of agency mortgage-backed securities per month. This extended QE stimulus is expected to replace the expiring Operation Twist, according to Capital Economics.

Analysts with Capital Economics predict the Fed will use the next Federal Open Market Committee, concluding on Dec. 12, to announce plans to continue buying $40 billion of long-term Treasury securities each month. The Fed also could adopt "numerical threshold for its guidance" in regards to the duration of short sales to remain at near zero, Capital Economics said.

"A number of participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the maturity extension program in order to achieve a substantial improvement in the labour market," according to FOMC November meeting minutes.

The Fed could opt either to buy $40 billion of longer-term Treasury securities per month to match its MBS purchases or $45 billion to compensate for the purchases under Operation Twist. Another option is to double its purchases of MBS to $80 billion per month, according to Capital Economics.

The decline in mortgage rates and bond yields since QE3 have caused Fed officials to take note of the benefits of buying MBS. However, rates continue to fall and it doesn’t appear that this trend will change. 

The main difference between long-term assets purchased under Operation Twist and its various QE programs is it hasn’t increased the overall size of the Fed’s asset holdings or monetary base because there are offsetting sales, Capital Economics asserted. 

Click on the chart to see asset holdings and monetary base.

The Fed announced it would begin buying $400 billion of long-term Treasury securities in Sept. 2011, with maturities of greater than six years and selling an offsetting amount of the shorter-term Treasury securities with maturities of less than three years.

The purpose of this was to potentially boost the economy "by reducing the duration in the bond portfolios held by private investors, thereby reducing longer-term rates on not just Treasury securities, but mortgages and corporate bonds too," Capital Economics wrote.

Operation Twist was originally scheduled to end in the middle of this year, but due to a deterioration in the incoming data for the spring, the Fed extended it until the end of the year. 

cmlynski@housingwire.com