Surprise, Surprise

The Federal Reserve has recently began another round of what it calls quantitative easing (dubbed in the press QE2, to reflect the second time the Fed has engaged in this policy since the financial crisis began and as a play-on-words with the famous passenger liner). And the amounts are huge; the Fed is spending $900 billion on this effort: $600 billion in new money and $300 billion by reinvesting proceeds from previous bonds it bought that have matured.

Quantitative easing is a fancy term for printing money, since it means that the Federal Reserve will buy bonds on the open market from investors and pay for it with newly created money (in the modern era, such vast amounts of newly created money are in the form of electronic credits deposited to an investor's account, not printed dollars - although such credits could of course be converted into dollar bills if desired).

The Fed's stated goal is to lower interest rates of U.S. government bonds, since, all else being equal, by adding its demand to the market, the price of bonds should rise (and interest rates decline as bond prices rise). This is the application of the laws of supply and demand to the bond market. And lower interest rates on government bonds tend to lead to lower interest rates on mortgages and loans to corporations, to higher stock prices, and to greater risk taking on the part of investors who seek higher returns away from government bonds.

But the problem with the Fed printing money is it raises the specter of higher inflation in the future, since, all else being equal, more money in circulation means prices should rise. This is the application of the laws of supply and demand to the money supply and the economy's price level. Further, if investors believe inflation will increase in the future, they will demand higher interest rates on bonds today to compensate them for investing their money at a fixed rate of return.

So some factors suggest QE2 will lead to lower interest rates, and other factors suggest it will lead to higher interest rates. The Fed is betting that lower interest rates will predominate, while many have criticized the Fed for downplaying the risks from higher inflation.

So who is right? Well, so far, QE2 has led to higher interest rates! That could change with new market conditions, but so far the Fed's plan is not doing what it intended.