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Friday, November 5, 2010

Bernanke's High Wire Act

Disconnecting the Heart Monitor

In my post last week titled, "Approaching the Zero Bound," I characterized the Fed's plan to buy hundreds of billions ($600 billion, it turns out) in U.S. debt as a "hypodermic needle to the economy's heart."

Actually, that analogy is not quite complete.

The Fed's money-injection plan, also known as quantitative easing, is like administering a hypodermic needle to the heart . . . after disconnecting the patient's heart monitor.

That's because the Fed's injection mode of choice -- buying up U.S. securities -- suppresses a key market signal: interest rates.

How's that?

Normally, when inflation kicks up, demand for loans becomes overheated, etc., buyers of U.S. debt balk, causing demand to flag -- and interest rates to rise.

Now, enter the Fed, and quantitative easing.

With the Fed guzzling U.S. debt -- goosing demand -- interest rates stay low or even go down.

As Bloomberg columnist Caroline Baum puts it (my paraphrase): 'playing with the yield curve is like trying to fool Mother Nature. Instead of increasing demand for goods and services, printing money just raises asset prices.'

Sure seems like the stock market agrees.

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