In the past, steep yield curves have been associated with sovereign-debt-ratings downgrades. Japan was stripped of its triple-A status by Moody's in 1998 and Standard & Poor's in 2001....The consequences of a U.S. credit-ratings downgrade could devastate the economy, pushing up borrowing costs and threatening the dollar." ("Is Steep Yield Curve Signaling Pain to Come?", Deborah Lynn Blumberg, Wall Street Journal)
The United States will not default because it pays its debts in its own currency, (and the Treasury can always just print more money) but the prospect of a ratings downgrade is quite real. That means it would cost considerably more to finance the debt. Also, long-term interest rates will rise sharply. That will crimp consumer spending, slow economic activity, and deal a death blow to the struggling housing market.
Bernanke's playing a dangerous game. If he's not careful, he could trigger a run on the dollar.
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