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) -- Expectations for next week's two-day meeting of the

Federal Reserve's

open market committee have taken a backseat to the Europe's uncertainty of late but there's still a lot riding on what the central bank does or doesn't do.

Capital Economics

Wednesday weighed on the growing perception that the strategy dubbed

Operation Twist

-- simultaneously buying long-term bonds and selling short-term ones -- is the most likely course of action for Ben Bernanke & Co., calling it the "best hope among limited options."

The firm said the Fed could elect to put $300 billion to work in this way, aiming to "lower long-term interest rates by extending the average duration of the Fed's asset holdings." It thinks the strategy, in conjunction with the Fed's pledge to keep short-term rates at near-zero levels through mid-2013, might be more effective than another round of traditional quantitative easing but said it probably wouldn't be enough to really move the needle.

"We wouldn't be surprised to see such an operation conducted oversix months, with sales/purchases running at roughly $50bn per month,"

Capital Economics

in a research note. "But an operation of that limited size would have only a small downward effect on the 10-Year Treasury yield, assuming it isn't already fully priced in, and an even smaller impact on the wider economy."

A $300 billion program would likely be disappointing for Wall Street as QE2, which was announced last November and wrapped up at the end of June, was a $600 billion bond-buying binge that aided in the stabilization of the economy and propped up stock prices but ultimately wasn't able to get spur enough growth to begin healing the job market.

Capital Economics


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Operation Twist

has a couple of advantages over a prospective QE3, including one as basic as a greater likelihood of passing muster.

"Operation Twist might prove to be more effective than a third round of traditional quantitative easing, at least as far as lowering long-term interest rates is concerned," the firm wrote. "It might also prove to be a little more palatable to the hawkish members of the FOMC, because it wouldn't require boosting thesize of the Fed's already bloated balance sheet."

Still, the bar can't be set too high, in

Capital Economics'

view, because interest rates aren't the problem.

"Borrowing costs are already extremely low, but households can't qualify to borrow at these rates and businesses lack the confidence to invest," the firm said.

Capital Economics

noted that the Fed currently owns roughly $1.65 trillion worth of Treasury securities with $150 billion of those set to expire in the next 12 months, $710 billion worth due to expire in the next one to five years, and another $778 billion slated to expire in more than five years.

The firm nixed the idea that the Fed could opt to cut the interest rates it pays on excess reserves, saying the impact would marginal, and expressed some surprise that the central bank hadn't shown more interest in QE3, theorizing the rise in core inflation was likely an issue as well as the political backlash that's followed QE2's disappointing impact. That doesn't mean the idea couldn't be revisited down the line.

"Nevertheless, there is still a chance that the Fed might resume quantitative easing sometime next year if economic growth remains lackluster and core inflation begins to fall again,"

Capital Economics



Written by Michael Baron in New York.

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