Jackson Jambalaya

George Melloan wrote a penetrating column in the Wall Street Journal last week about how the Fed is forcing the economy to paint itself into a corner. Worth reading for both sides:

The year-end "fiscal cliff" tax deal sent shivers through the bond market, driving the price of 10-year Treasurys to the lowest level since April. There was a good reason. The stubborn resistance by President Barack Obama and Senate Majority Leader Harry Reid to spending cuts left no further doubts about their lack of interest in the nation's No. 1 economic problem, massive federal deficits.
The bond-market decline came despite the Federal Reserve's renewed program to gobble up yet more government debt. Presidents of some regional Federal Reserve Banks are growing nervous about this program, judging from the December minutes of the Federal Open Market Committee, which guides Fed policy. Jeffrey Lacker of the Richmond Fed, Richard Fisher of Dallas and Esther George of Kansas City have been among the most outspoken in voicing fears that continuation of the Fed's manic buying—now running at $85 billion a month in Treasury and agency paper—will ultimately destroy the dollar. The concerns expressed in the FOMC minutes didn't cheer the bond market either. (KF note: One reason Barney Frank and others want to get rid of the regional governors)

These are signals of dangerous times. Forget about the next Washington dog-and-pony show on the debt ceiling. The bond market will ultimately dictate the future of U.S. monetary and budgetary policy.

Bond markets only obey the law of supply and demand. When the flooding of markets with American debt causes the world to lose confidence in dollar-denominated securities, the nation will be in deep trouble. The only force standing in the way of that now is the Fed's support of bond prices. But regional Fed presidents are prudently asking how long that can be sustained.

Mr. Obama currently is riding high, pumped up by his success in resisting Republican budget-cutting demands during the "cliff" talks. But the deal he muscled through Congress is a hollow victory. His so-called tax on the wealthy will produce scant revenues. The money sucked out of American pocketbooks by higher payroll taxes will curb consumer demand, further slowing already weak economic growth. Only entitlement reforms, which the president refuses to consider, can shrink the deficit enough to reduce the danger it poses.

The Fed's worst fear is that despite its long-term commitment to buying up government debt, it will lose control of interest rates. That's why the early-January upward blip in bond yields was a yellow warning light. If Treasury bond prices decline significantly from the artificial levels that massive Fed purchases have supported, several things will happen, none of them good.

First of all, government borrowing costs will rise, making it even more difficult to control the deficit. Second, the value of the Fed's gargantuan and growing $2.6 trillion portfolio of Treasury and government-agency mortgage bonds will decline. It won't take much of a portfolio loss to wipe out the Fed's capital base. Without capital of its own, it would become a ward of the Treasury, costing the Fed what little independence it has left to defend the dollar.

Even now, the Fed faces a cruel dilemma. It can let bond prices fall and suffer the unhappy consequences. Or it can keep on its present course of buying up more hundreds of billions of Treasury paper. That course inevitably leads to inflation.

Over the past four years, the damage to the dollar has been partly ameliorated by global investors fleeing weak currencies elsewhere for the relative safety of the dollar. But there has to be a limit to how long that will be true. We already are seeing signs of renewed asset inflation not unlike the run-up that occurred in the first half of last decade. Stocks and farmland are up and housing prices are recovering from their slump....

Inflation can ultimately destroy the bond market, as it did in 1960s Britain during the government of the socialist Labour Party. No one wants to commit to an investment that might be worthless in 10 years, never mind 30 years.

Throughout history, governments have inflated away their debts by cheapening the currency. That process is well under way through the Fed's abdication to irresponsible government. If Fed policies continue, another huge tax—inflation—will weigh down the American people. The politicians will try to escape public censure, as they always do, by blaming it all on "price gouging" by producers, retailers and landlords. A substantial cohort of the press will buy into that phony rationale and spread it as gospel.

The Fed's dilemma is in fact everyone's dilemma, given the universal stake in the value of the dollar. And all because an American president and a substantial number of senators and representatives don't understand one simply fact: In the end, the bond market rules.

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is the author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).