A Divided Fed? What Will They Do Next?

by Justin Weinger on January 7, 2010

For the first time in a while, it looks like there might be some division among the Federal Reserve’s policy setting members regarding when the central bank should begin to tighten its easy money policies that have been credited with keeping the U.S. economy afloat during the worst economic downturn since the Great Depression.

The Federal Reserve has expanded its balance sheet by purchasing $1.5 trillion worth of Treasury bonds and mortgage-backed securities, as well as making loans available to banks and investment firms for collateral that would usually be deemed too high risk and unacceptable.

In addition to expanding its balance sheet, the Fed has lowered the Federal funds rate to a record low of “near 0%.” Many revolving consumer loans – credit cards, home equity loans, etc. – are tied to the federal funds rate, so the lower the rate, the cheaper these loans and debt become.

The Federal Reserve’s measures have helped to thaw the credit market, slow the bleeding in the housing market and slightly revive consumer spending, which, in turn, has the economy in a fledgling recovery.

So, at what point does the Fed back off and start to tighten its monetary policy?

On one hand, you’ve got policy members – most importantly, chairman Ben Bernanke – who appear to want to make sure the economic recovery has a strong footing before starting to tighten the screws.

While waiting to remove the stimulus would certainly help the economy in the near-term, it could end up creating more bubbles (read: commodities) and push us towards an inflationary recession at some point down the road.

On the other hand, you’ve got policy members – most importantly, inflation hawk Thomas Hoenig – who want to tighten monetary policies sooner rather than later.

While acting now will help to squash the threat of inflation down the road, it could kill the current economic recovery and undo all of the work done to this point.

Based on the fact unemployment is above 10% and will likely climb higher through at least the middle of 2010, and the dollar has been strengthening lately, I expect the Fed will wait a while before pulling its monetary stimulus and raising short-term interest rates. Plus, their track record shows the central bank tends to be a bit behind the curve (read: not pro-active).

What are your thoughts?  What would you like to see the Fed do?  What do you think they’ll do?  Leave your comments below!

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