More on the Fed's purchase of Treasuries

Caroline Baum at Bloomberg notes yet one more set of unintended possible consequence as a result of the Federal Reserve's plan to buy $300 billion in long-dated U.S. debt.

If Fed chief Ben Bernanke is successful in his commitment to preventing deflation at any cost, buying 10-year Treasuries at 2.5 percent will turn out to be a losing proposition for investors.

Why? Real 10-year yields, as reflected in inflation-indexed Treasuries (TIPS), are currently at 1.38 percent. That’s below the historical average of 1.8 percent since the creation of the Federal Reserve in 1913, according to Jim Bianco, president of Bianco Research in Chicago. (Can you guess whether real rates were higher or lower before the U.S. had a central bank?)

Take out the World War II period, when the Fed pegged long- term rates to help the Treasury’s war effort, and the average is probably closer to 2 percent to 2.5 percent, according to Bill Poole, former President of the St. Louis Fed and now a Bloomberg News contributor.

Based on my admittedly unsophisticated math -- subtracting 10-year TIPS yields from 10-year nominal Treasury yields -- expected inflation is 1.24 percent over the next 10 years. (Second quiz question: What are the chances of inflation being that tame with the Fed pulling out all the stops?)

In other words, “there’s no real return on 10-year notes at this level,” Poole says.

As noted previously here and here, these purchases are opening up a whole new can of worms when it comes to whatever meaning the bond market provides regarding inflation.

The central bank really ought to just come out and say, "So as not to affect the 'inflation expectations' implied by treasury market prices, the Fed will always by equal amounts of Treasuries and TIPS".