By Charles Hugh Smith, DailyFinance

NEW YORK ( DailyFinance) -- Keeping interest rates low is a linchpin of the Federal Reserve's quantitative-easing policy (QE2), a $600 billion bond-buying program aimed at stimulating the economy. The basic idea is that low rates will encourage businesses to borrow and expand -- including hiring more employees -- and will boost housing sales by making mortgages cheaper for potential homebuyers.

Unfortunately for the Fed, bond yields and interest rates having been rising since it began buying Treasury bonds as part of QE2 in the fourth quarter of 2010. And they seem likely to continue rising despite the massive intervention by the Fed. Here are some of the broader factors that are working against the U.S. central bank:

1. The Fed's policies are perceived as inflationary: Charles Plosser, a member of the Fed's policymaking committee and the president of the Federal Reserve Bank of Philadelphia, has been a leading critic of the bond-buying program. Although it's intended to pump cash into the economy and keep interest rates low, Plosser argues that QE2 may backfire by stoking inflation.
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Inflation has been so low recently that the Fed has been more concerned about deflation and has been trying to get at least some inflation back into the economy. But it's a question of balance and control because inflation acts as a "hidden tax" on the economy: Goods and services cost more, leaving households and businesses less money for consumption and investment.

And inflation isn't just bad for wage earners. It's also the mortal enemy of long-term bonds. As inflation rises, yields (and interest rates) must rise too, lest investors lose money in buying a bond. If a bond yields 3% (about what a 10-year Treasury bill pays now) and inflation is running at 6% a year, the bond holder will lose 3% of his capital every year.

Even worse, the market value of the bond would plummet. To understand this, imagine the bond yield and the bond's market value as two ends of a see-saw. If yields decline, existing bonds rise in value. If yields climb, the value of existing bonds falls.

For instance, if bond yields rise from 3% to 5% -- still a historically low rate -- that would mean that all existing bonds would be repriced so that they, too, yield 5%. A $100 bond that now pays 3% -- or $3 -- would be worth only $60 at 5%. That's a 40% cut for the bondholder -- a very painful loss of capital.