By Louis S. Barnes Friday, April 20th,2012 Long-term interest rates have stabilized safely in the Fed-controlled zone,10-year T-notes 2.00% and mortgages 4.00%. Stocks and other markets hope for QE3, perhaps as early as next week’s Fed meeting, but that move will likely wait for either weaker global economic data, or inflation falling toward deflation, or both. US data is softening — not anywhere near a new double-dip conversation, but not accelerating to self-sustenance, either. March retail sales did okay, up .8%, but the housing recovery ballyhooed since winter has been exposed as a promotional feature: new starts fell 5.8% in March, new permits rose (but nobody gets a paycheck for one of those), and sales of existing homes fell 2.6%. One theory: diminished inventories of listings have crimped sales. Uh-huh. “Saudis Buy, Destroy Science For 200MPG Cars!” Inventories are down, but prices in many markets are firming, and the combination encourages sales. Local is local, but Colorado Front Range listings year-over-year are down 40% and sales are up at least 15%. In an unquantifiable development, beneficial for the moment, some 5.5 million distressed homes sit in formaldehyde, embalmed by new state and federal impediments to foreclosure and sale. This inventory is concentrated in Sand States. Instead of rapidly selling and clearing these markets, it may be a long-term benefit to convert them into National Sacrifice Zones… park rangers, tours, T-shirts, postcards and all. While we all wait on the Fed, and to see if Club Med peoples will overthrow their ICU physicians, intent on hooking patients to more maintenance machinery while standing on their oxygen hoses, a moment for — BOO! — inflation. The financial Right and many long-cycle thinkers (who still don’t understand the 1970s) are certain that the Fed’s QE inevitably will cause inflation, executing the perpetual conspiracy of government to inflate away debt. Meanwhile the Left says economic recovery would be easy if only the Fed would induce 4% or 5% inflation. In simplest terms, a central bank’s job in a too-hot economy is to drive interest rates far enough above inflation to cool it off; and in a too-cold economy, far enough below to warm it up. The Fed’s normal tool is the ultra-short-term, “Fed funds” rate; however, at 0% since 2008, and core inflation at 2%, the Fed can’t get “far enough below” to induce recovery. Standard far-enough models today say the Fed should be 6%-8% below zero. Short-rate policy frustrated, the Fed has instead in the last three years pulled long-term rates below inflation: that’s been a partial effect of QE, assisted by the Fed’s commitment to keep the Fed funds rate close to zero at least through 2014, and as of last September further assisted by “Operation Twist,” letting short-term Treasurys run off its balance sheet and buying long-term ones. Hence the 10-year T-note at 2%, at least 1% below CPI, when its yield in an ordinary economy should be 2% above. To have that effect, the Fed has had to buy all new long-term Treasurys — some argue more than the new issuance. The economy depends on a lot more IOUs than Treasurys. Suppose markets saw the Fed allow or induce an inflation run-up. If the Fed continued to buy long Treasurys, those rates could stay under control. However, other long paper — corporates, munis, mortgages — would begin to roar in yield and soon become unsalable at all. The Fed for the moment has the “yield curve” under control. Partly because of its low-rate assurances and purchases, but every bit as important because it promises to keep inflation in bounds. Both Right and Left are wrong. In the debt-soaked modern world, completely unlike the 1970s, owners of IOUs will defend themsleves. By selling. At the first whiff of tolerated inflation, fists will pound on Mr. Sell Button, and rising rates will choke the inflation that would rob IOUs of value. Deflation and default ensue. Losing control of the yield curve is the ultimate nightmare. That is what has happened to Club Med. One day you can sell only short paper, and later even that only at a discount, no matter what the central bank does. Inflation is neither help nor direct hazard; the hazard is failure to live within means, all else is consequence.