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Martin Feldstein: The Fed's Dangerous Direction

By keeping long-term interest low, the Fed has removed pressure on the president and Congress to deal with deficits.

By Martin Feldstein | The Wall Street Journal

The Federal Reserve is heading in the wrong direction. What the central bank describes as "unconventional monetary policy" is creating dangerous bubbles in asset markets that will lead to higher future inflation and is supporting the explosive growth of the national debt. Its new "communications strategy" will, moreover, only further confuse markets.

The Fed's recently announced plan to buy $85 billion a month of government bonds and mortgage-backed securities will keep long-term interest rates at historic lows, with a 1.6% yield on 10-year Treasurys and a negative yield on 10-year TIPS (Treasury Inflation-Protected Securities). The Fed sees its strategy as a way of boosting the prices of equities, real estate and other assets. It has indeed boosted asset prices, although the increase in individual balance sheets has had very little positive impact on real economic activity.

Once the Fed stops buying securities, however, interest rates will rise and asset prices, including stock prices, will fall. This will have serious adverse effects on investors, particularly highly leveraged institutions and pension funds.

Long-term interest rates are also likely to rise in the future because of the higher inflation induced by the Fed's current policy. Because of the Fed's purchases of bonds and mortgage-backed securities, commercial banks have $1.4 trillion more in reserves than is legally required by the size of their balance sheets. The banks can use these excess reserves to create loans and deposits, which will increase the money supply and fuel inflation.

Continue at The Wall Street Journal

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