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QE2 is not only unnecessary but foolish (cont.)




Even as there appears to be an overwhelming consensus that the FOMC will commence a second round of quantitative easing following next month's meeting, the evidence is mounting that this is not a good idea. As this chart shows, the bond market is getting more and more worried about inflation. 10-yr Treasury yields are anchored by the Fed's pledge to keep short rates low for a long time, and by the evidence that suggests that economic growth is not accelerating and unemployment will thus remain high for a long time. But 30-yr Treasury bonds have no such constraints. They have risen 35 bps since the end of August, while 10-yr yields are essentially unchanged. Meanwhile, 10-yr real TIPS yields have fallen almost 70 bps over the same period as demand for inflation protection has increased. All this adds up to an 80 bps rise in 5-yr, 5-yr forward inflation expectations (as shown above in red), the Fed's preferred indicator of the market's inflation expectations.

This one chart should be held up at the FOMC table, with the following admonition: "Gentlemen, the market is clearly telling us that to move ahead with QE2 would increase inflation expectations beyond what is consistent with our mandate to seek relative price stability. Meanwhile there is little or no evidence that economic growth has been constrained by a lack of liquidity. I vote to tell the world that we remain disposed to avoid deflation at all costs, but to make no changes to monetary policy for the time being." What would be very exciting to hear—but highly unlikely, unfortunately—is at least a few words to the effect that fiscal policy (e.g., extending the Bush tax cuts) is the more appropriate policy lever to be pulling at this juncture.

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