Issue of the week: Bernanke’s easy-money gamble

It won’t work, said Sudeep Reddy and Luca Di Leo in The Wall Street Journal. That’s the consensus among economists on the Federal Reserve’s decision “to give the economy a lift” by printing more money. Fed Chairman Ben Bernanke is committing the Fed to buy $600 billion in long-term Treasury bonds from banks over the next eight months, a central-bank tactic known as quantitative easing, or QE. If all goes according to plan, the money flowing into banks will soon flow out again in the form of loans to businesses, and will be used to start hiring. QE has worked before. Last year, the Fed began buying $1.75 trillion in Treasurys and mortgage-backed securities, halting the economy’s “downward spiral.” But even proponents of what’s being called QE2 say it “will provide only modest support for the economy.” Meanwhile, skeptics worry it could backfire altogether, “sowing seeds of unwelcome inflation.”

Perversely, Bernanke hopes that fear of inflation spreads, said Caroline Baum in Bloomberg.com. Here is his logic: Right now, inflation is minimal—less than 2 percent annually. Let’s say a business can borrow today for 10 years at 4 percent. If inflation is expected to rise to 3 percent, then the real cost of borrowing is only 1 percent—highly attractive terms. This assumes, however, that interest rates remain constant while inflation rises. But it’s just as likely that interest rates will rise along with prices, defeating the whole purpose of QE2. In that case, QE2 will “postpone the necessary rebalancing of the U.S. economy,” said Edward Chancellor in the Financial Times. “The U.S. needs to save and invest more to ensure its long-term prosperity,” yet Bernanke is threatening consumers with higher inflation to induce them to spend now—before prices rise. But interest rates are already low, and consumers, burdened by debt, are fearful of spending. “Bernanke is tilting at windmills.”

I’m not worried about failure, said Bill Fleckenstein in MSN’s Moneycentral.com. I’m worried the Fed will succeed “beyond its wildest dreams.” Bernanke is about to discover how hard it is to control inflation once it’s unleashed. Markets, as former Fed Chairman Paul Volcker will attest, are reluctant to believe central bankers when they commit to “break the back of inflation.” In 1979, then–Fed Chairman Volcker raised short-term rates to a sky-high 12 percent to wring inflation out of the economy. Yet the price of gold, a barometer of inflation expectations, “screamed higher” for the next three months. And if the markets were skeptical that inflation could be controlled then, how much more skeptical will they be now, with a Fed chairman not known for possessing Volcker’s grim anti-inflation resolve?

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