On October 9, 2009, the Financial Times reported that the Federal Reserve was testing a key tool for draining liquidity from the financial system. Ten days later, the Fed confirmed that it had in fact been conducting reverse repos, but the tests were not an indication of a change in monetary policy.
That same day, a Barron's cover article appeared, sharply suggesting Fed chairman Ben Bernanke should already be raising rates and removing liquidity. The article cited that gold, oil and other commodities, as well as the stock market were are already rising, and that the dollar was falling. These are all signs of excess money in the system. (For more, read our Federal Reserve Tutorial.)

Clearly the Federal Reserve is aware that it will need to remove the excess liquidity and raise rates in the future. But at this point, it's not exactly sure, or it isn't saying, when that will be, and it's staying the course despite the calls to do otherwise. This is the smart strategy, and here's why.

A Difficult Balancing Act
The mandate of the Federal Reserve is simple to understand, but complicated to accomplish. It desires stable prices and low unemployment, a difficult balancing act to say the least. The most important thing is stable prices, hopefully rising slowly at around 3% per year. This allows growth without excess inflation. Also, it is more important to fight inflation than high unemployment as inflation hurts everyone. Unemployment, even at today's high levels, impacts far fewer people. So first things first, stable prices, then low unemployment. (Check out our Inflation Tutorial for background knowledge on this important economic concept.)

When inflation is low and unemployment is high, the focus is on increasing economic activity and reducing unemployment. This is the situation today. So, while the signs of potential inflation are taking shape, higher stock market and commodity prices along with a lower dollar, prices of goods and services haven't been rising very much, if any. Until this changes, it's likely the Fed will stay the course and not raise rates.

Differing Goals
The goals of the pundits can differ from this. They can call for a stronger dollar - making that their primary goal. The problem with that is the moves to increase the value of the dollar would likely slow the economy and increase unemployment. So it would be at odds with the Fed's goals. Other pundits may desire leaving the excess liquidity in the system to push the market rally even further. Again, that isn't the Fed's goal. The Fed decision making doesn't stray too far from its mandate of stable prices and high employment. To do so would risk not accomplishing one, or possible both, of those primary objectives. While others may suggest policy shifts to push their goals, it's unlikely the Fed will listen.

Another major difference in the Fed and the pundits is that the Fed typically needs to see evidence that something is happening before it acts. The pundits espouse a future that may or may not come to fruition. It's the difference between thinking we are going to have inflation, and actually having it. This lag can drive those that were correct crazy, but it's the only sensible course of action. The alternative would be to have the Fed try to anticipate economic activity before it occurs and act to offset it. The Fed correctly leaves the reading of the tea leaves to the traders and pundits and acts based on evidence, not projections.

Careful Planning
Also, the Fed is keenly aware of the importance of the message it sends to the markets. It's crucial that confidence in its leadership be maintained and that it doesn't send mixed messages. A confused market creates panic. Typically, interest rate moves by the Fed have been in small, steady increments, and changes in direction were clearly telegraphed so as not to shock the markets. However, on the rare occasion when the Fed wants to get the market's attention, it has moved interest rates between meetings and in larger increments. That's very unlikely here.

Most firms don't hire people until demand for their products and services exists, so employment is typically a lagging indicator of economic activity. In other words, firms need to sell more products and services before they hire more people. And, of course, selling more products and services can be inflationary. Therefore, the most likely course from here is that inflation will increase before unemployment totally subsides.

Future Fed Moves
Though the Fed is staying put right now, it's very likely that it will be raising rates and reducing liquidity before strong employment returns. But it won't take this action because of an article in a paper, or a pundit on television. It will need to see evidence of prices rising before it raises interest rates. But once the Fed does see that evidence, the pieces are being put in place already, and it will act. (Learn more in The Treasury And The Federal Reserve and How Interest Rate Cuts Affect Consumers.)

Related Articles
  1. Economics

    Can the Market Predict a Recession?

    Is a bear market an indication that a recession is on the horizon?
  2. Economics

    How Negative Interest Rates Work

    Policymakers in Europe go for the unconventional: negative interest. What could happen?
  3. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  4. Fundamental Analysis

    3 Times the FOMC Got It Right This Century

    Learn about three times that the Federal Open Market Committee (FOMC) and the Federal Reserve took positive steps to help the economy in the 21st century.
  5. Economics

    The Truth about Productivity

    Why has labor market productivity slowed sharply around the world in recent years? One of the greatest economic mysteries out there.
  6. Investing News

    Today's Sell-off: Are We in a Margin Liquidation?

    If we're in market liquidation, is it good news or bad news? That party depends on your timeframe.
  7. Fundamental Analysis

    Quantitative Easing Report Card in 2016

    Find out why quantitative easing has not worked, despite the best efforts of the Federal Reserve, and how it has fueled the national debt problem.
  8. Products and Investments

    The One Thing Your Portfolio Must Always Have

    Portfolio diversification is essential in any situation, but especially so as the market finally returns to fundamentals.
  9. Stock Analysis

    3 Risks Emerging Markets Debt Faces in 2016

    Learn about the major risks for emerging market debt in 2016. Discover how low interest rate policies by central banks fueled the growth of debt globally.
  10. Investing News

    How Interest Rates Can Go Negative

    Central banks from Europe to Japan have implemented a negative interest rate policy (NIRP) in order to stimulate economic growth.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is comparative advantage?

    Comparative advantage is an economic law that demonstrates the ways in which protectionism (mercantilism, at the time it ... Read Full Answer >>
  3. How does the Wall Street Journal prime rate forecast work?

    The prime rate forecast is also known as the consensus prime rate, or the average prime rate defined by the Wall Street Journal ... Read Full Answer >>
  4. What's the difference between microeconomics and macroeconomics?

    Microeconomics is generally the study of individuals and business decisions, macroeconomics looks at higher up country and ... Read Full Answer >>
  5. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  6. How do you make working capital adjustments in transfer pricing?

    Transfer pricing refers to prices that a multinational company or group charges a second party operating in a different tax ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center