The Federal Reserve is many things to many people. For some, it's an abomination, but for most of us (of the saner variety) it provides a much needed function in shaping our economy. The Fed has a dual mission of keeping a lid on inflation and encouraging healthy economic growth. The difficulty is that in times like today, it's like walking a tight rope about as thick and strong as dental floss.
On the one hand, the Fed needs to keep money loose to move the economy out of recession and back to healthy growth numbers. On the other hand, if the Fed keeps rates low for too long, the ugly monster that is inflation will return with a vengeance. The last, best example of a time like this was in Japan in the early part of its 'Lost Decade'.
Without going into too much detail, the outcome in Japan is something that we'd like to avoid - generally speaking, a 'Lost Decade' isn't good. So what's the Fed to do? Hellifiknow, but there's only two ways to fall off of the tight rope.
Raise Rates Too Soon, Double Dip Recession
If the Fed tightens the money supply too soon, it will choke off the recovery underway and we will land in a double dip recession. This also means that we will have wasted a good chunk of the fiscal stimulus (government spending) because another recession could prompt ever more spending. This would hurt the economy in the short run, but also in the long run as the country would be saddled with more debt.
Raise Rates Too Late, Inflation & Recession
Should the Fed raise rates too late, we'll find ourselves with a period of inflation - potentially stagflation - that will erode the purchasing power of consumers and businesses. The last time we went through a period of high inflation, Paul Volker pursued a policy of ever increasing interest rates to reign in the beast. The byproduct of this policy was an increase in unemployment, and....recession. By the way, that recession wasn't a small one either.
An Unknown Margin for Error
The problem with our current state of affairs is an unknown margin for error. Sometimes we'd all like to think that if you put enough really, really smart people in a room together that they'll be able to cure all that ails us. Unfortunately, the world doesn't work that way.
While Ben Bernanke and the staff of the Federal Reserve have a great depth of knowledge, we can't depend on them to be perfect. As a result, it's important to do what you can to address the uncertainties we face. A low debt load, stout cash reserves, and a balanced portfolio will always serve you well.
By the way, have you rebalanced your portfolio during the run up? You might want to look into it.
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