Fed's strategy failed to work as planned

How's that QE2 working out for you?

To answer the question, we first have to establish the goals of a second round of quantitative easing as laid out by Federal Reserve Chairman Ben Bernanke (above). The Fed's purchases of US Treasuries "affect the economy primarily by lowering interest rates on securities of longer maturities," Bernanke explained in a November 19 speech in Frankfurt. Lower rates equate to more "accommodative financial conditions," he said.

Bernanke went on to say that QE is really a misnomer for what the Fed is doing. Quantitative easing works by increasing the quantity of bank reserves. Treasury purchases, on the other hand, "work by affecting the yields on the acquired securities" and forcing investors to buy higher-yielding, riskier assets, he said. Thanks for the clarification.

Based on those metrics, how is QE2 faring?

Credit spreads, or the difference between the yields on risk-free Treasuries and other debt securities, have narrowed. Check. Stocks have rallied. Check. As for the primary intent of QE2, which is to lower long-term interest rates, that hasn't worked out according to plan.

Stronger growth

Not so, say some observers, who argue that the rise in long-term rates is prima facie evidence QE2 is working, that higher rates correlate with stronger growth. That was quick. What happened to those "long and variable lags" with which monetary policy is said to operate?

A better, or more nuanced, interpretation of the Treasury market's response might be that QE2 was unnecessary, with the increase in yields suggesting an improving economy independent of any renewed stimulus on the part of the Fed. The yield on 10-year US government notes set a low for the year of 2.4 per cent in early October. After the November 3 announcement of QE2, yields skyrocketed, reaching 3.53 per cent last week before retreating to 3.33 per cent last Monday. The yield on five-year notes jumped more than 1 percentage point as well.

Inflation expectations

Even worse from the Fed's point of view is the rise in real yields, adjusted for inflation expectations: from 0.36 per cent to 1.2 per cent on 10-year inflation-protection securities, or TIPS. Policy makers teed up the idea that fanning inflation expectations would cause real yields to fall, providing oomph to the economy at a time when the federal funds rate is already close to zero.

Instead, the lion's share of the increase in yields since QE2 got under way has been in real rates, with inflation expectations inching higher.

Of course, the Fed can always fall back on the claim that yields would be higher without its intervention, a politically popular tactic because such assertions can't be proved.