NEW YORK (Reuters) - Federal Reserve chief Ben Bernanke has opened the floodgates of cash, a high-risk bid to shore up the economy that could prolong the housing market pain it intended to forestall.
Investor reaction to the central bank's aggressive half percentage point reduction in the benchmark interest rate to 4.75 percent was unequivocal.
Stocks rallied on the belief that a return to easy money would revitalize the economy and corporate profits. But long-dated Treasury price dived, pushing long-term interest rates higher as inflation vigilantes in the bond market worried the Fed was letting down its guard on price stability.
This means the very sector that has dragged economic growth into a rut -- housing -- could be challenged further as 30-year mortgage rates, linked closely to 10-year Treasury yields, shoot higher.
"Fed easing may drive up the yield curve from the long end, which tends to drive up mortgage rates, triggering sharper interest rate resets," warns Ashraf Laidi, chief FX analyst at CMC Markets US. "This may also mean a faster pick up in the rate of mortgage delinquencies and potential evictions, which should trigger a notable scaling back in consumption."
Yields on 10-year Treasuries jumped up immediately after the Fed's decision Tuesday and extended that rise on Wednesday to 4.54 percent, their biggest one-day spike in six weeks. If inflation fears linger, higher mortgage rates might follow.
Bernanke grappled with doubts over his inflation-fighting credentials early in his tenure as Fed Chairman. His vocal and, in hindsight, misguided focus on the threat of deflation won him the nickname "helicopter Ben," a reference to comments he once made about taking extreme action to stem a prolonged economic slump like Japan's.
Still, strong statements to the contrary eventually won him many fans on Wall Street. Now, analysts are questioning this professed focus.
Critics also argue that, despite assurances from policy-makers, the Fed's move looks like a rescue of Wall Street -- and one that might hurt Main Street as well.
"This is a pretty blatant bailout for excessive risk-taking over the past few years," said Robert Macintosh, chief economist at Eaton Vance Management in Boston.
"This should make people less confident for the Fed to achieve their number one objective which is keeping inflation at bay."
Indeed, history suggests mortgage rates will follow long-term bond yields higher, particularly if inflation fears become pervasive.
Over the past 10 years, 30-year fixed-rate mortgages for prime borrowers have featured interest rates anywhere from 1.38 percent to 2.26 percent above 10-year note yields. That spread mushroomed as much as a half percentage point in just the last three months as banks clammed up on lending.
And things could get worse as several inflation signals are flashing red. Yields on the 30-year bond US30YT=RR, the most sensitive to long-term inflation expectations, have climbed nearly a quarter percentage point since the prospect of a heftier rate cut was first floated following a jobs report that showed the first contraction in hiring in four years.
Other forces are also at work that may exacerbate the inflation pressures already running through the economy.
Oil prices, for one thing, continue to carve out record highs, the latest registering well over $82 a barrel. Gold, seen as another signpost of future inflation, has hit a 28-year high.
To be sure, U.S. core inflation has been creeping lower.
But it has yet to fall convincingly within the Fed's comfort zone of 1-2 percent. Moreover, economists have grown increasingly impatient with the use of a measure that excludes essential items like food and energy. The core inflation figure, they say, masks the rising cost of living and therefore arguably under-rewards bondholders for the extra risk.
Some also maintain a softening economy exerts enough of a drag on prices to prevent inflation from building.
But that pull is a double-edged, with the dollar's steady downward slog pushing up the prices of imports that represent a key component of economic activity.
The path between too little growth and too much inflation is a narrow one.
"The Fed is clearly concerned about lending or lack thereof crimping economic activity and for now is willing to trade inflation for economic stability," said Tom Sowanick, chief investment officer at Clearbrook Financial in Princeton, New Jersey.