TightWind is written by Kyle Baxter. Stay Hungry. Stay Foolish.

The Federal Reserve is purchasing $600 billion long-term treasury bonds in an attempt to drive long-term interest rates down, and thus to encourage lending and borrowing. That’s the official reason; causing moderate inflation in the short-term, which reduces the cost of debt for borrowers at the expenses of lenders, and devaluing the dollar against foreign currencies and thus making U.S. exports more competitive are both reasons for it, too.

Those that support it say there really is no chance of it causing harmful amounts of inflation, because inflation is already so low right now. I agree with them in the short-term; I don’t think it will cause harmful amounts of inflation right now, especially because banks are sitting on cash reserves as it is, and I don’t think providing them with even more reserves is going to suddenly cause them to change their minds. The reason they aren’t lending isn’t for a want of capital—it’s because of an uncertain economy. So that part is correct.

But in the longer-term, damaging inflation is a very serious worry. Let’s say that, in two years, the economy moderately recovers and begins a steady incline, as it should. This would cause banks to substantially increase lending, especially because their cash reserves are so strong. At this point, we would have the potential for terribly damaging inflation.

Richard Posner explains:

Suppose businesses and consumers increase their spending, and the banks lend the $1 trillion they’re holding in excess reserves (accounts in federal reserves banks, equivalent to cash). The ratio of money in circulation to goods and services will rise, and inflation will tick upward, perhaps more than desired. The Fed can reduce the money in circulation by selling some of its huge inventory of bonds, but by doing so it will raise interest rates (just as increasing the demand for bonds lowers interest rates, increasing the supply raises them), which may choke off the economic recovery. If it hesitates to sell bonds and retire the cash it receives from the sales, expectations of inflation may soar, and inflation rise to a dangerous level; and to bring it down the Fed will then have to sell bonds after all, draining money out of the private economy at a rate that brings on the kind of very sharp recession that the nation experienced in the early 1980s. 

In other words, a program meant to drag us out of one recession may push us into another one. That’s not especially shocking; it’s difficult to predict just what the economy is doing at any one time and guide it along. Attempting to direct the overall tenor of the economy, as the Federal Reserve does, is a business fraught with potential for serious error.