Remember this the next time you're trying to figure out the effects of the Federal Reserve's battle to keep the economy growing: There's no such thing as a free lunch. By aggressively cutting interest rates, the Fed has kept this economy from sinking into a deep recession. Low rates have propped up consumer demand for everything from cars to houses. And that's been critical because the corporate side of the economy is stuck in what amounts to a capital-spending recession. But the benefit of a relatively shallow recession, at least so far, comes with major costs. First, the Fed's massive intervention in the financial markets and its decision to pump up the money supply have led to serious distortions in the way the financial markets price risk. In both the bond and the stock markets, many prices don't adequately discount future risks right now. Second, the Fed's efforts to stave off a recession today raise the odds that the recovery tomorrow will be anemic. In effect, we've borrowed from future growth to keep the economy rolling in the present.
What California Bonds and Ford Bonds Have in Common
Let's take a hard look at prices and risk in today's bond and stock markets. I'll start with bonds. Today you can buy a tax-exempt bond issued by the California Department of Water Resources that yields 4.82%. That's a pretty tempting rate on a bond that matures in 2008, if you've noticed that the 10-year Treasury note is yielding just 3.7% or so at the moment. It's even more tempting if you live in the high-tax state of California and can take full advantage of the bond's exemption from state taxes. So it's not really surprising that the price of this bond has increased 14% since it was issued just this month. In other words, a bond that originally yielded 5.5% and sold for $10,000 not so long ago, today costs $11,412 and pays just 4.82%.