One major part of the job of the Federal Reserve is to keep the economy on an even keel, not booming too much nor going into recession. (The other major parts are to protect the banking system, and to prevent inflation.) So when the Great Recession hit in 2008, the Fed dropped the Fed Funds rate to near zero, which has the effect of lowering interest rates generally, hopefully stimulating the economy. It also began flooding the street with money through open-market operations, buying federal bonds, thus increasing the cash balances of banks, giving them more money to lend.
That’s the easy part of keeping the economy on an even keel. The tricky bit is when and how abruptly to reverse course. The balance sheet of the Fed has grown enormously in the last few years and at some point the money it has created has to be withdrawn from the economy, again by open-market operations, this time selling federal bonds. If that weren’t done, it’s possible a 1970s inflation could break out. But there is always strong political pressure to keep money cheap.
The economy has clearly been improving, with corporate profits up and housing prices now rising. Since most families’ net worth is concentrated in their homes, a rising housing market makes people feel richer. And that makes them more likely to go out and buy, pumping up the economy. To be sure, unemployment is stubbornly high, but it’s a lagging indicator, tending to recover more slowly than other economic indicators.
So Ben Bernanke, the chairman of the Federal Reserve, has begun to hint that the Fed’s quantitative easing is drawing to a close. It’s been buying $85 billion worth of federal bonds a month. The markets have been reacting badly to Bernanke’s Delphic pronouncements. The Dow was above 15,300 last Tuesday. Right now it’s below 14,700, a drop of four percent. With the prospect of interest rates rising, bonds have been declining as well.
But these are short-term flutters in the stock market. It is corporate profits that determine the movement of equities. As long as corporate profits are strong and growing, the market will not swoon. Rising interest rates, however, will cause bond prices to decline in proportion.
The Fed has an unenviable job right now. If it acts too slowly, inflation could set in. If it acts too quickly, the economy could be tipped back into recession. And those with a dog in the fight—which is practically every interest group in the country—will be pushing hard to get its way.