Congress fails to see QE2 has already raised interest rates and inflation

Peer into the sometimes mind boggling data series from the 10-year US treasury market and you can clearly see interest rates rising from 2.4 per cent last October to just over 3.6 per cent. That is a 50 per cent rise in a key long-term interest rate in less than six months.

Yesterday Fed chairman Ben Bernanake appeared before the Budget Committee, his first appearance before Congress since November’s mid-term elections saw Republicans seize control of the House of Representatives. He vowed to keep rates low and said inflation was not a problem in the US.

Fed’s role

But there is still a widespread misunderstanding about the Fed and interest rates. It sets the overnight rate for banks but the bond markets are where the long term rates are set. And yields are definitely up since QE2 started. Mortgage rates are therefore going up, and the value of bonds where most pensioners have their money is falling. Bond prices fall as yields rise.

It is the same story for inflation. US official inflation data excludes food and energy – a leftover from the 70s when government was also trying to distort the data – and without food and energy it is true that inflation is not looking so bad. With those vital elements of the family budget and inflation is rising, like interest rates.

if you want to know what this means for stock markets then look at India, the worst performing stock market apart from Egypt this year, down 14 per cent. Food accounts for 70 per cent of the average family budget and so the impact of inflation is felt most acutely in India. Interest rates have been raised four times. It is a real bear market with billionaires blaming the media for bear raids on their stock.

Dividend payments

There is another more simple explanation for falling stock prices. If bank deposits are paying higher interest rates then share prices have to fall to push up dividends.

So what seems most likely to follow rising interest rates and inflation globally are falling bond and stock markets. The two rarely fall together. This was last seen in the 1970s in very similar circumstances to today, and eventually drove investors into a precious metals bubble.

Will it be any different this time? QE2 is inflating commodity prices and pushing interest rates up and that will be bad for financial markets, even if many of them have yet to discount this effect.