The markets reacted with exuberance in November when Federal Reserve Board Chair Janet Yellen, then the nominee, declared that she would continue the Fed’s stimulative monetary policy. A few weeks later on December 18, the markets also reacted exuberantly when the Fed said it would pare back its stimulative policies much earlier than expected.

Go figure. Were these contradictory reactions, in former Fed Chairman Alan Greenspan’s memorable phrase, “irrational exuberance?”

From a long-term investment perspective, they may be. For while the Fed’s stimulus policy, known as quantitative easing, may be necessary to goose the economy, it could sow the seeds for inflationary trouble ahead. Some Fed critics worry about the course of action the Fed will take, but the real issue may be more basic: the benchmark the Fed uses to determine when to take action.

First a little background on the roots of the Fed's current dilemma. The U.S. normally has a consumer-led economy. But during the recession, with consumers holding on to their wallets, banks unwilling to lend, companies refusing to spend and hire, and the federal government curbing spending, the Fed was the only game in town for combating the high unemployment and sluggish GDP growth in the aftermath of the financial crisis.

Quantitative Easing

So the central bank embarked on “quantitative easing”—buying mortgage-backed securities and Treasuries--to pump money into the economy and stimulate growth. The Fed’s $85 billion-a-month bond-buying binge kept interest rates low while accumulating a $4 trillion portfolio. The Fed in 2012 said it would start to tighten the money supply and raise interest rates when unemployment drops to around 6.5% (as of this posting, the rate is 7.0%), but now it says it will keep rates low well past that benchmark. It figures the economy won't be strong enough to withstand higher interest rates until the unemployment rate falls further.

Some Fed critics such as Anthony B. Sanders, a finance professor at George Mason University, are terrified of what could happen when the Fed changes course. Next to a picture of the ill-fated Hindenburg on his blog, “Confounded Interest,” Sanders recently wrote: “Let’s see what happens when Janet Yellen is faced with the problem of tapering and selling the massive Fed Balance Sheet.”

The central bank clearly faces a dilemma. With inflation below 1% (well below its 2% target), the Fed wants to promote economic growth and avoid crippling deflation, since deflation prompts delayed buying in the expectation prices will drop. But the Fed has a tendency to be stimulative for too long. So some Fed watchers believe that with the money supply ballooning, the Fed should boost rates in anticipation of inflation. That would preserve the hard-won, inflation-fighting credibility it earned in the 1980s when it helped push the prime rate to 21.5% to arrest inflation, which had soared to 13.5%.

The big bond fire sale Fed critics fear would take so much money out of circulation that it would cause a spike in interest rates. With stable or growing demand for money, a smaller supply of it means its price—interest rates—would rise. But the Fed doesn't have to take that route. Under the current plan, just by slowing purchases over time and holding some bonds until maturity, the Fed can take its foot off the pedal without slamming on the brakes with a massive selloff. Fears of a Hindenburg explosion are overblown.

Labor Statistics Tricky

That said, the Fed’s reliance on the unemployment rate for determining when to pull back on bond purchases may prove troublesome. That’s because statistics on the supply of labor are notoriously tricky to evaluate, particularly when it comes to gaging their relationship to inflation.

The 6.5% target is well above the 5.5% figure that conventional wisdom says is “full employment,” the level below which the supply of workers is so tight that wages rise and create an inflationary spiral. The reason for the 6.5% target was to start tightening the money supply before inflation kicks in. But at its December meeting, the Fed’s Open Market Committee said it would maintain the current low targets for the federal funds rate-0% to 0.25%- “well past the time that the unemployment rate declines below 6.5%.“

That could lead the Fed on to treacherous terrain. The Fed evidently believes there’s still plenty of slack in the labor market because the number of unemployed and part-time workers is large. The labor participation rate has plunged from 66% before the recession to 1970s levels of 63%. People are not considered part of the work force if they have stopped looking for work. The prospect that these folks on the sidelines can jump in when the economy rebounds, the thinking goes, keeps wages low and inflation at bay.

But a number of factors have changed the calculus in recent times. For starters, a significant portion of the decline in labor participation is due to the retirement of baby boomers, who will not come back to the work force. Gerald Cohen, a senior fellow at the Brookings Institution and former Fed staffer, estimates that a third of the decline in the official participation rate is due to the aging population.

Low Wages Unrealistic

In addition, some of the unemployed and workers no longer looking for jobs don’t have the skills employers need. And even if they have the right skills, the long-term unemployed, like the 1.3 million who lost their unemployment benefits at the end of the year, are not attractive to employers. The long-term unemployed don’t put much downward pressure on wages because “given the choice, employers will hire someone who’s been working recently,” says Katherine Abraham, a University of Maryland professor and former Bureau of Labor Statistics commissioner.

Employers’ belief that the labor oversupply can keep wages down may prompt them to offer unrealistically low wages for job openings, which would help explain why advertised jobs rose 63% in October compared with October 2009 while hiring rose only 18%. Add all this together and it suggests that wages for qualified, active workers will have to rise if employers want to fill those openings. That, in turn, may mean the full-employment rate is higher than the 5.5% the Fed assumes. “It may be that it’s a bit higher than it was before we went into the recession,” Abraham says.

Former Fed Chairman Ben Bernanke said at his December 18 news conference that once unemployment gets to 6.5%, the Fed will look at a variety of factors, including hiring, quits, vacancies, participation, long-term unemployment, and wages. That looks a lot like fine-tuning, which has never been able to prevent booms and busts (think housing).

It’s relatively easy to assess the demand side of the macroeconomic equation: Just look at spending data and household balance sheets. Analyzing the supply side of the equation—plant capacity, the labor pool, and productivity—is harder. “The greater risk for policy mistakes is misunderstanding the supply side of the economy,” says Cohen.

The Bottom Line

So on paper, it may look as if the Fed has a lot of running room because of what seems like a lot of slack in labor markets. But if inflation erupts and interest rates rise, hammering both bonds and stocks, people may focus on the wrong cause, the need to unwind the Fed’s $4 trillion bond position.

Instead the pitfall could be difficult-to-divine unemployment stats.

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