Many investors fear that the Fed’s impending exit from QE2 will have a very damaging effect on the financial markets. Whether they are right will depend on the nature of the exit, and its impact on bond yields. An end to the Fed’s programme of bond purchases, without any increase in short rates, is unlikely to be sufficient, on its own, to trigger a major bear market in bonds and equities. But an end to the Fed’s “extended period” language on interest rates would be a much greater threat. I still do not expect this to happen soon.

Recently, the Fed has purchased 60-70 per cent of all the bonds which have been issued to finance the US budget deficit. Some influential analysts (Bill Gross of Pimco among them) argue that bond yields will rise sharply when the Fed withdraws its life support from the bond market. But there are some powerful advocates, including the Fed chairman himself, for an entirely contrary point of view. Ben Bernanke told Congress in February that he did  not expect to see “a big impact” on bond yields when the Fed ended its asset purchases.

The Fed has hardened its thinking on this question in the past couple of years. It has  decided that QE reduces bond yields via its effect on the total stock of outstanding bonds, and not via its impact on the flow of bonds purchased in any given period. If this is the case, then