Did Someone Forget to Tell the Bond Market About Quantitative Easing?

The idea behind the Fed's quantitative easing program is the Fed will print money that will be used to buy long term Treasury bonds. Its purchases, to total as much as $600 billion by September 30, 2011, are supposed to push down interest rates, thereby stimulating the moribund economy with lower borrowing costs.

A problem, it would appear, is that someone forgot to tell the bond market. A month ago, the yield on the 30-year Treasury bond was about 3.75%. Today, it trades around 4.25%. The 10-year Treasury note was yielding around 2.4% a month ago. Today, it hovers in the range of 2.6%. Are the bond traders crazy? Received wisdom in the financial markets is never to fight the Fed. But the bond market seems to be determinedly paddling upstream.

Then again, what if bond traders have it right? What if quantitative easing will be inflationary? It increases the quantity of dollars in the financial system, which is a precondition to inflation. Additionally, it puts downward pressure on the dollar, which raises the price of imports. That will have an inflationary impact. Bond investors demand higher yields when confronted with the prospect of inflation. And higher interest rates dampen economic growth. So QE, before it's hardly out of the gate, has already made things worse.

The Fed, however, has a reply: raising expectations of inflation would be good, since that would stimulate consumer spending. Beleaguered consumers, desperately trying to save some of their stagnant or shrinking incomes as a buffer against hard times, will be strong armed into spending their money whether or not they like it. It's for their own good, and the Fed is destroying their financial security in order to save them.

So quantitative easing is a win-win for the Fed. If QE lowers long term interest rates, it stimulates the economy by lowering borrowing costs. If QE increases inflationary expectations, it coerces consumers into spending. With the U.S. economy 70% consumption, a revival of consumption means revival of the economy. Of course, this works only if the Fed can prevent inflation from spinning out of control. High inflation doesn't produce prosperity--the late 1970s, a time of double-digit inflation, were an American nightmare, not the American Dream. The Fed has to produce Goldilocks inflation: not too hot and not too cold. Chairman Bernanke insists the agency can do that.

We must be in Lake Wobegon, where all monetary policy is above average. Here, a pure money print, which is what QE amounts to, cannot produce a bad result. One would have thought that conjuring up money from thin air would be undesirable. At least, so it would appear to those of us who had always thought money was supposed to be earned from productive work.

When the Federal Reserve comes across like a late night TV ad for no money down real estate, we know we're in trouble. The enduring foundational principle of all economics is that there ain't no such thing as a free lunch. The Fed is coming close to transgressing this, the most fundamental of the laws of economics. Those who put themselves above the law set themselves up for a fall. Perhaps it is true that actual national wealth can be created by flushing printed money into the financial system and deftly removing it when inflation flares. Then again, desperate times are when hope is most likely to triumph over experience. When it does, experience can administer painful lessons.