“A Bull Market in Pessimism”

     The following is a brief summary and response to the Economist article “A Bull Market in Pessimism” from Aug. 21, 2010.

     Currently in a tough place, the Federal Reserve is facing two threats: deflation and inflation. The Fed must tread lightly to avoid spiraling either monetary effect out of control. Were the Fed to inflate its way out of potential deflation, real-returns would rapidly turn negative (especially given the current low interest rate environment), thus leading to a mass exodus of Treasury bond-holders. Furthermore, were the fed to raise interest rates, bond-holders would also be squeezed out of the market, given the inverse relationship between bond prices and yields, the value of their bonds would decrease. As if the situation were not challenging enough, by purchasing Treasuries with the monies provided by maturing mortgage debt the Fed is adding to the downward pressure on Treasury yields. These combined effects; along with increased investor demand for Treasuries (putting further downward pressure on yields) has positioned the Fed with an inflexible exit strategy. Given the challenging situation the Fed’s attempts to alter monetary policy will likely be rife with error. 


The Economist