Fed has awakened bond vigilantes who fear inflation

On October 29, the bond vigilantes, after being in hibernation for many years, suddenly awoke and fired a warning shot at the Federal Reserve, the stock market and millions of other investors.

All would be well-advised to pay attention, especially the Federal Open Market Committee.

The warning shot took the form of a Treasury inflation-protected securities auction at which the bond vigilantes bought four-and-a-half-year bonds at a price that represented a negative yield.

The demand for the TIPS, which carried a minuscule 0.5% interest rate, was such that it drove up the price of the bonds to the point where the yield was -0.55%, meaning that the buyers expect inflation to rear its ugly head before April 15, 2015, and are willing to pay a premium to buy the inflation protection offered by TIPS.

In effect, the buyers are rejecting the Federal Reserve’s belief that deflation is a greater concern than inflation, that further quantitative easing is needed to stimulate the economy and that it can be undertaken without sparking inflation.

The Fed didn’t heed the warning. On Nov. 3, Federal Reserve Chairman Ben S. Bernanke said that it would buy an additional $600 billion in longer-term Treasury securities by the end of the second quarter next year.

By buying the Treasuries, the Fed will be increasing the money supply by as much as $600 billion between now and next June.

Mr. Bernanke clearly is more concerned about the weakness in the economy now, instead of the prospect of inflation in a few years.

As a student of the Great Depression and Japan’s “lost decade” from 1991 to 2000, when that country’s economy stagnated, he is determined to apply the lessons of both, especially the latter.

Most analysts think that the “lost decade” was the result, in part, of monetary-policy errors in Japan, especially monetary stimulus that was injected too late and withdrawn too soon.

Mr. Bernanke seems determined to provide all the monetary stimulus necessary to get the U.S economy moving. If the $1.7 trillion of Treasuries and mortgage-backed securities that the Fed bought between December 2008 and March 2010 — quantitative easing No. 1 (QE1) — wasn’t enough, then another $600 billion (QE2) will be tried.

Mr. Bernanke is gambling that the rapid expansion of the money supply will stimulate faster growth without triggering runaway inflation, and that the Fed will be able to get control quickly if any inflation does occur.

Although many economists argue that there is little danger of inflation because of the slack in the economy, particularly with the unemployment rate at 9.6%, others suggest that the significant increase in commodities prices in recent months hints at possible inflation.

This rise in commodities prices occurred as it became more apparent that the Fed would decide to use QE2, and it accelerated as the announcement of QE2 drove the value of the U.S. dollar down against most other major currencies.

The U.S. Dollar Index hit a low for the year of 75.74 on Nov. 4 after the formal announcement of QE2. It had been sliding from a high for the year of 88.586 in June as analysts picked up hints that the Fed was leaning more and more toward quantitative easing.

The cheaper dollar might help U.S. exports in the short run, but it will increase the cost of imports of all kinds, beginning with commodities.

The Dow Jones-UBS Commodity Index increased to 153.79 on Nov. 8 from a low of just under 125 in June.

That increase in commodities prices likely will make its way into the U.S. prices of many goods in the not-too-distant future. It has already begun to show up in the prices of oil and gasoline.

Mr. Bernanke has awakened the bond vigilantes. Until now, he has been able to keep them from pushing up yields on ordinary Treasuries, but they have warned him that they are getting nervous about inflation, and long Treasury rates have begun to creep up despite his efforts.

When he backs off from his quantitative easing, if there is any hint of inflation, they will pounce and push rates up.

That will be bad for bond investors, and probably even stock investors, as rising interest rates often push down stock prices.