Inside the Fed's fight (pg. 2)

  @Money September 17, 2013: 1:58 PM ET

WHY THE DOVES DON'T QUIT: If only inflation were the problem

Fisher's Ritalin remark might say more than he means. Many parents would point out that sometimes a struggling student needs exactly that sort of help to get through some tough years and go on to be productive. And is anyone going to argue that the U.S. isn't still wobbly? Fewer than half of the jobs lost since the recession have come back.

Chicago Fed president Charles Evans has long thought the Fed should be making it clear that unemployment should be lower. "I've been outspoken in saying that we should keep the federal funds rate at zero until we see an improvement in the unemployment rate, at least until we reach about 6.5%," he told MONEY in November. In mid-December, Bernanke announced that Fed policy would do just that.

Talking about 6.5% unemployment may not be as colorful as "parasitic wastrels," but in the world of Fed wonks, it's the kind of thing that makes people sit up and listen.

The Fed adopted Evans's ideas "lock, stock and barrel," says Princeton's Alan Blinder, a former Fed vice chairman. "Plainly, we're not at the limit of quantitative easing. There is no limit."

That's bold stuff because, as James Bullard of the St. Louis Fed noted in a recent speech, the central bank does not have a great history with targeting job growth; the belief that policymakers could engineer very low unemployment helped set the stage for the great 1970s inflation.

Related: The hidden perils of inflation

The Fed's current unemployment threshold is comparatively modest and is paired with what Evans, 54, calls a "safeguard" inflation threshold of 2.5%, but it's a loud signal that the Fed wants to keep a heavy foot on the gas until jobs come back.

The doves acknowledge that low rates are making life hard today on retirees who depend on the income from their savings. Evans insists that trying to raise the Fed funds rate today wouldn't help anyone. What will help is a roaring economy, which lower rates should stoke. There's no point trying to push rates up now to have them drop again if unemployment spikes.

As Evans puts it, "The longer we spend fortifying our policies to make sure we get the most vibrant, robust demand possible to generate growth, the sooner we'll get higher rates."

So what about inflation risk? Hawks, it should be noted, have been worrying over inflation for years now, with little of it materializing, except for some temporary surges in energy and food prices. Because incomes show little sign of rising broadly across the economy anytime soon, the Fed sees little risk of consumer prices taking off.

"There just isn't inflationary pressure in the economy right now," Yellen says. "We don't have enough spending. The economy is weak." Indeed, some market measures, including the amount of yield buyers are willing to forgo to grab the inflation-protected version of Treasuries, called TIPS, still showed expected inflation at 2.5% a year or lower for the next decade.

When the Fed needs to unwind what it's done, Yellen says, the tools exist to keep the process orderly.

In addition to selling back the securities on its balance sheet, it can reduce the amount of dollars sloshing around in the economy by paying banks higher rates on the money they hold in reserve.

Despite the wide gap between the two sides, some doves and hawks agree on this: Congress has some work to do.

Fisher's ire is focused on lawmakers' inability to set predictable policy on taxes, spending, and regulation and to chart a course toward a balanced budget. Evans -- and quite loudly Bernanke himself -- have pushed for accommodative fiscal policy to assist their monetary efforts.

As shown by the bickering over what to do about the "fiscal cliff," the powerful anti-stimulus of automatic tax hikes and spending cuts nobody claimed to want, quick action isn't something the political system seems able to deliver any longer. For better or for worse, the Federal Reserve is now the most powerful economic policymaker on the field.

WHAT IT MEANS TO YOU: Betting on a sure thing -- until it isn't

Wary of how confusing these debates can be to investors -- Who's really winning? What's happening next? -- Bernanke has consistently pushed the Fed to do a much better job of beaming information about its policy path to the general public. None of that cryptic maestro act that America got from Alan Greenspan.

This isn't some reform-minded sunlight-in-government effort, however. "Communication is a policy tool in and of itself," says Yellen. "It's not only current purchases of assets or the current level of the Fed funds rate that matter, but also market expectations of the paths of those things over time."

Translation: By telling the world that it's set on 6.5% unemployment and that it will tolerate inflation of 2.5%, the Fed is all but screaming at the market that it won't pull the rug up -- all to coax investors, lenders, and businesses back into confidence.

The Fed is also saying that safety will continue to cost. Today's yield on a 10-year Treasury bond is just 1.79%, which means in real terms that you are losing money holding on to it even if inflation is a bit less than 2.5%. Steeper rises would be even more painful.

For you, the Fed's stance has a few logical implications:

Don't run from stocks -- but don't try to chase a rally either. The adage on Wall Street is "Don't fight the Fed." So far, the bank's commitment to monetary stimulus has buoyed equities, which suggests, barring even uglier economic surprises, a relatively bullish outlook.

Related: Why market timing is so hard

The wrinkle here is that the Fed is just one partner in the market-expectations tango. On the other side, investors have now had time to digest the idea that Bernanke and company are determined to keep policy accommodating and to account for that in prices. It could be that many of the gains the Fed could conjure have already happened.

Don't stretch for big bond yields or returns. Given the lousy rates on safe funds, the yields on bonds and bond funds with a longer maturity or more credit risk can look appealing. They've also had unusually high recent returns, thanks to the historic rate drop. (Bonds' prices rise as rates fall.)

Rates are likely to stay low for some time, but when they do rise, aggressive bond investors could be in for a nasty surprise.

Spread out your risk: Hold longer-term bonds that will do well if the Fed holds the line, but also stash assets in short-term instruments. (CDs can earn more than short Treasuries.) Should rates spike, you'll take advantage when the short-term investments mature.

And don't go overboard on high-yield or more exotic kinds of debt. "There's so much pressure on people to add income at these low-yield levels," says Michael Cloherty, head of U.S. rates strategy for RBC Capital Markets. "The concern is that people stop hedging some of these risks, and then you get everybody scrambling for the door simultaneously."

Do be a long-term fixed-rate borrower. What's bad for bondholders is good for anyone who can handle some debt. Don't be in a hurry to pay off your mortgage.

Do have an inflation hedge. Although fast-rising prices do not look likely in the near future, moving some of your bond portfolio into inflation-protected TIPS will give you a buffer if a shock does come.

Is there a lot of uncertainty here? You bet. Even savvy investors struggle to predict when the Fed will act or what its effects will be. Four-plus years after the crisis, investors and savers remain in a tight spot. There's only so much even the Fed can fix. To top of page

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