killer buffalo

Since the financial crisis led the American economy off a cliff last fall, Fed Chairman Ben Bernanke has been trying to drive it the quick way back up the mountain.  Lately though, as he realizes the quickest way is often the most dangerous, he’s been steering the Federal Reserve with the steady determination of a toddler.

When the subprime mortgage industry collapsed in the summer of 2007, the Fed cut its Federal Funds Rate for the first time in nearly four years and continued to lower the interest rate until it reached a range of 0-0.25%.  At first, yields on Treasury securities fell as uncertain investors pulled money from the stock-market and used it to purchase Treasuries—traditionally the safest ways to store money.

But in recent months the Fed’s low interest rates and a growing perception that housing and banking stocks are a once-in-a-century bargain have provoked the beginnings of an economic recovery: investors are withdrawing money from low-risk savings like time deposits and Treasuries and investing them in higher-return areas like real estate and stocks.  Fewer investing in Treasury securities means higher yields are required to sell Treasury securities.

Mr Bernanke seems to think he can change that.

Last March, he announced that the Fed would buy $300 billion in Treasuries—a move this column has already criticized—over the following six months.  Employing the theory of supply and demand, more buyers for Treasuries ought to decrease yields at which Treasury bonds are sold.  Yet phantom buyers don’t have the same effect.

Reserve funds at the Fed are given to the Federal Reserve Bank by the Treasury.  Thus, using them to buy Treasuries—loans to the Treasury that allow it to create money—amounts to what economists call “quantitative easing” or what the layperson calls “printing money.”  And whatever you call it, it results in inflation.

Since higher inflation makes lenders require higher interest rates, fears of future increases in inflation drive up yields on Treasuries, particularly long-term securities like the 10-year note and the long bond.  In the end, this means having the Fed buy Treasuries in order to decrease their yields will have the opposite effect—it will increase yields.  And if Mr Bernanke continues to implement simplistic view of supply and demand, he might misinterpret the rising yields that will result as a sign that the Fed isn’t buying enough Treasuries.

By September we could have high yields on Treasury bills and hyperinflation.

And the difficulty in controlling inflation, especially once it passes 10%, is the reason that it’s such a thorny issue.  Even if high inflation doesn’t originally result from the Fed buying Treasuries, economists predicting high inflation could trigger it.  When workers observe high inflation or think they observe high inflation they demand higher wages; then when wages rise, inflation results, and workers continue to demand raises.  As long as people expect high inflation to continue, the economy won’t escape the wage spiral, inflation will continue to chase its tail, and economic resources will be poorly allocated, all because the Fed wanted to lower Treasuries’ yields.

Mr Bernanke should understand this: the recent climb in yields on Treasuries is of his own making—it is the product of thirty months of a low Federal funds rate, which is intended to goad Americans into taking money from places like Treasuries and spending it.  If Mr Bernanke thinks the yields can be lowered by any means other than an interest rate hike, then there’s a space for at the Psychiatric Institute of Washington DC.  It’s safe, small, and only three miles from the Federal Reserve.

In the meantime, the Fed can advertise the job opening.  It has one hundred twenty million toddlers to choose from.

-David Lamb

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