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File photo of the U.S. Federal Reserve building in Washington.

STELIOS VARIAS/Reuters

The most recent Federal Reserve monetary policy release left some monetarists shaking their heads.

This was not due to policy makers' suggestion that they would allow for inflation above 2 per cent, as their dual mandate requires a target in that range during periods of high unemployment. Rather, it was their announcement that they would loosen monetary policy and purchase additional longer-term Treasury securities, which would "maintain downward pressure on longer-term interest rates."

I wish the Federal Reserve had said why it believes its moves will cause long-term yields to stay steady or decline, as this would appear to violate basic monetary theory.

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There is a certain Economics 101 logic to the idea that the Federal Reserve buying up long-term bonds will cause their price to rise (and therefore yields to fall). All else being equal, an increase in the demand for almost any product or asset will cause the price of that asset to rise. This applies equally to financial assets as it does to widgets, so this would appear to be the Fed's thinking.

This story, however, is incomplete, as all else is not equal. Long-term bond yields are largely dictated by (and positively correlated with) future expectations of economic growth and inflation. Expansionary monetary policy causes an increase in inflationary expectations, which should cause bond yields to rise. Although the Federal Reserve is buying up these bonds, the price of the bonds will ultimately fall as the private sector moves out of U.S. bonds and into equities, commodities and foreign bonds. This position was vindicated Wednesday, as after the Fed's announcement the 30-year U.S. bond yield rose more than five basis points.

Now, it is true that the Federal Reserve has only announced it will buy additional bonds in the future; it has yet actually to do so. The timing of the purchases, however, is not relevant to the discussion, since the future purchases are known to the market and thus are priced into the asset. Bond yields may fall in the future, but it will not be due to future bond purchases that were in the recent announcement.

While the Federal Reserve's announcement should be welcome news to investors, I am puzzled why policy makers believe it will have the effect of lowering bond yields. Monetarist theory argues for the opposite outcome.

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