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Congress is gridlocked, consumers are pessimistic, and firms are barely hiring. To speed this recovery up -- or to prevent a double dip -- it might be up to the Federal Reserve. Last week it announced its latest attempt to revitalize the economy. Its chief target appears to be the still anemic housing market. Will the new policies work?

The Fed's Plan

The central bank will take two different actions meant to jumpstart the economy. First, there's "Operation Twist." The Fed will attempt to push down long-term interest rates by purchasing $400 billion in Treasury securities with six to 30 year terms. The program will last for nine months -- through June 2012.

But here's the clever part: the Fed will sell shorter-dated Treasuries in exchange for bank reserves. This will prevent the Fed from having to expand its balance sheet to purchase longer-term Treasury securities. The relative increase in short term rates should be small, since short-term Treasuries are in high demand and the Fed is keeping other short-term rates low through its other policies.

The Fed announced another policy change as well. It has been reinvesting its maturing principal in additional Treasury securities. The central bank will refine that approach by investing maturing principal from its agency bonds and mortgage-backed securities in additional agency mortgage-backed securities. In this way, it will keep the size of its mortgage securities exposure level. But more importantly, this action will also increase the demand for mortgage-backed securities, which should push down mortgage interest rates.

The Medicine the Housing Market Needs?

In fact, the major target for all of the Fed's new action appears to be the U.S. housing market. Both Operation Twist and the new MBS reinvestment policy should help to push down mortgage interest rates. And they're low already: this week Freddie Mac reports the average 30-year mortgage interest rate at just 4.09%. Through the Fed's new policy, rates should easily dip below 4%.

Operation Twist could also help the reinvestment policy to have a more dramatic effect: as mortgage interest rates begin to decline, we should see mortgage refinancing soar. That means more maturing principal, which will provide even more capital for the Fed to reinvest in MBS to push down mortgage interest rates even further.

One question outstanding is whether the government will create a headwind or a tailwind for the Fed effort. If it decides to respond to Operation Twist by issuing more longer-term Treasuries, then this will partially neutralize its effect: additional supply would soak up some of the new demand the Fed is creating. But it might be hard for the government to ignore the opportunity to get more ultra-cheap long-term financing, particularly given the nation's precarious debt situation.

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