The end of quantitative easing.

• Author: Adams, Tucker Hart
• Position: The ECONOMIST

THE TOPIC ON EVERYONE'S MIND THESE DAYS seems to be, "What will happen when the Federal Reserve ends quantitative easing?" Most of the people I talk to have a vague idea that it will result in higher interest rates and higher inflation, but no clue as to why.

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It's pretty simple, actually--just the old law of price determination at work. Every month the Department of the Treasury issues a mountain of debt in the form of Treasury bills, notes and bonds. Some of this is to refinance debt that is rolling over, and some of it is new debt to pay bills that aren't covered by tax revenues. The latter finances the deficit.

When the supply of something goes up all other things being equal--the law of price tells us that cost goes down. But remember, the interest rate isn't the price of government debt. Rates move in the opposite direction from the price at which lie security sells. With all of the new debt filtering into the market, we need new buyers to keep prices from falling and rates from rising.

For a while, with the world economy mired in serious recession, entities looking for safe investments provided the new buyers. Eventually though, they decided they had about enough of U.S. securities, so the Fed stepped in as the new buyer. The unusual part was not only the size of their monthly purchases ($85 billion in the first half of 2013), but also the fact they were buying longer-term debt, rather than simple Treasury bills.

At first we might ask, "Why doesn't the Fed keep up the purchases indefinitely"? Low interest rates are good for the economy and they just print the money for the purchases, so they never run out." There's the pesky little problem of low interest rates hurting savers, but that isn't most people's main worry.

That's where the inflation concern comes in. When the Fed purchases Treasury securities, the money goes into accounts at commercial banks. It seems no different from when you or I buy something.

But there is one huge difference. Our purchase simply moves money from one bank to another--the amount of money in circulation goes unchanged. The Fed's purchase is with brand-new money. To oversimplify, think of them running a printing press in the basement to print new bills used for...