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Federal Reserve Chairman Ben Bernanke. (J. Scott Applewhite)
Federal Reserve Chairman Ben Bernanke. (J. Scott Applewhite)

Taking Stock

The Fed v. inflationistas: Who's right? Add to ...

The debate about the U.S. Federal Reserve's decision to wade into the Treasury market in an effort to stimulate more lending, borrowing and spending grows stranger and more heated by the day.

Economists on both sides are gleefully firing broadsides at each other over two main points of contention: whether quantitative easing part two - dubbed QE2 - has any hope of working, and whether it will trigger a bout of inflation that will make the current troubles exceedingly worse and wreak havoc in the bond market.

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Retired central bankers Alan Greenspan and Paul Volcker think QE2 is a big mistake. Foreign governments from Berlin to Beijing have waded in with their own self-serving opinions. And Fed officials have launched an unprecedented public counter-attack against the critics, including a handful inside the Fed system itself who think Fed chief Ben Bernanke and his supporters are trying to put out a debt-fuelled forest fire with a blowtorch.

Mr. Bernanke decided on Friday that the whole problem might be semantic. Buying bonds, he insisted, is not the same as printing money.

The "use of the term quantitative easing to refer to the Federal Reserve's policies is inappropriate," he told a conference in Frankfurt organized by the European Central Bank.

"Quantitative easing typically refers to policies that seek to have effects by changing the quantity of bank reserves, a channel which seems relatively weak, at least in the U.S. context. In contrast, securities purchases work by affecting the yields on the acquired securities and, via substitution effects in investors' portfolios, on a wider range of assets."

This bizarre exercise in hair-splitting probably won't cause such well-known inflationistas as famed bond fund manager Bill Gross or James Grant, editor of the influential Grant's Interest Rate Observer, to change their minds about the dangers of currency debasement and high inflation.

Mr. Grant recently joined Harvard historian Niall Ferguson and a gaggle of other conservative economists and investors in denouncing QE2. And Mr. Gross still likens it to the central banking version of a Ponzi scheme. QE2, he warns, may well signal the end of a three-decade bull run for bonds.

If enough smart people keep telling investors to be very afraid, at some point they will start listening. Throw in the knotty Irish crisis - where we see unfolding the sequel to the Great Icelandic Banking Collapse - and it's not surprising that some analysts are donning their undertaker suits when discussing the outlook for bonds.

"I think it's the risk for the bond market," veteran Canadian fund manager John Braive says of the spectre of inflation. All the public hand-wringing has investors thinking: Gosh, maybe the Fed's wrong. Maybe it doesn't have to do this. Maybe inflation's coming back. So the fear pendulum's swinging back."

If inflation "does get out of hand, it's terrible for the market, and it's going to force big changes fiscally," says Mr. Braive, vice-chairman of CIBC Global Asset Management. "If the bond vigilantes take yields up from 3 per cent to 6 per cent, debt-service costs are going to go through the roof, and it could lead to massive political changes."

That is not to say that Mr. Braive should be counted among the inflation-is-nigh crowd. The Fed-bashers are saying "this high-powered money will eventually end up pushing up prices. And I'm saying that a lot of things all have to work properly for the transmission mechanism to work from the Fed's balance sheet to the [bank]lending side to pushing up prices. And that's a really tough thing to occur."

In other words, the Fed infusion somehow has to translate into more willing lending than we have seen from shell-shocked U.S. bankers, as well as higher demand from equally reluctant borrowers. Yet "everything you see on velocity [of money]is that it keeps going down," Mr. Braive said.

He's not alone in assessing the risk of inflation as low. "The U.S. is deep in an output gap, faces deflationary forces, and is a clear case for more monetary and/or fiscal stimulus," Robert Kessler, a well-known bond adviser to institutional investors, said in a note last week.

Signs in the recently enthused stock market that things are getting better have left the impression that QE2 is both unnecessary and inflationary. That isn't the case, Mr. Kessler argues. "QE 1, 2 or 'n' is not powerful enough to do what is being imagined."

What if, as seems likely, the $600-billion (U.S.) of QE2, spread between now and June, has little or no impact on the real economy or the stubbornly high U.S. jobless rate? Stimulus proponents are already urging the Fed to boost its asset purchases to the $2-trillion range. That ought to ratchet up the volume of an already noisy debate.

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