Under these conditions, the Fed will want to raise the interest rate to prevent an acceleration of inflation.

When the economic recovery begins to accelerate, commercial banks will want to use the large volume of reserves that the Fed has created to make loans to businesses and consumers.

Moreover, the Fed s approach is severely compromised by the so called zero bound on interest rates.

In the previous tightening cycle, which began in 2004, it took the Fed two years to normalize the policy rate.

Right before the Fed acted, the Reserve Bank of India raised its benchmark short term interest rate by 25 basis points, to 6.25 , to fight inflation, and China s central bank now indicates that it might raise interest rates further.

The Fed s actions have involved what former Fed governor Larry Meyer calls liquidity tools, as opposed to interest rate based monetary policy.

In the US, the Fed was sharply raising rates.

That is why the Fed has been taking steps to become more transparent it releases the minutes of Federal Open Market Committee meetings and publishes transcripts with appropriate delay, while FOMC members give speeches detailing their views. Moreover, in a recent innovation, the Fed now publishes the inflation and interest rate forecasts of FOMC members and Reserve Bank presidents.

So the Fed could, in principle, decide to raise the federal funds rate even before the unemployment rate reaches 6.5 .

In the same timeframe, the ECB should move its official rate from 1 to at least 2 , while the Bank of England should aim for 5 .

True, the US Federal Reserve has tried to prevent a recession by cutting its interest rates. But the Fed cannot endow the banks with new equity capital and prevent a credit crunch.

Politicians will not sit quietly, however, if the Fed attempts to raise rates.

With unemployment now at 7.6 and falling only slowly, the Fed may not be ready to raise the federal funds rate until 2015.

As a result, only the Fed s interest rate instrument, Stein and Tarullo argue, can get into all of the financial system s cracks.

Fighting the Fed

While the Fed s governing statutes, unlike those of the European Central Bank, explicitly include a mandate to support employment, the announcement marked the first time that the Fed tied its interest rate policy to a numerical employment target.

If inflation turns out to be higher (a very likely outcome of the Fed s recent policy), the interest rate on long term bonds could be correspondingly higher.

If credit expands too rapidly, the Fed can raise the interest rate that it pays on deposits. Sufficiently high rates will induce commercial banks to prefer the Fed s combination of liquidity, safety, and yield to expanding the quantity of private lending.

The Fed was late in beginning the interest rate normalization process, and it is now paying a price.

The Fed has pursued its strategy of low long term interest rates in the hope of stimulating economic activity.

The Fed Under Fire

The Fed s Communication Breakdown

The Fed s Dollar Distraction

First, the Fed is trying to give relatively specific guidance about the future path of the federal funds rate (the overnight rate at which commercial banks lend to each other).

(The Fed raised its benchmark federal funds rate from 1 in 2004 to 5.25 in 2006 and held it there until August 2007).

The Fed, of course, has been forced to turn to QE, as traders call it, because its normal tool for fine tuning inflation and growth, the overnight interest rate, is already zero.

The average interest rate paid for overnight reserves in the US has been well below the 5.25 per year that the Fed still publicly says is its target.

The Bush administration cut taxes. The Fed cut interest rates in response to the 2001 recession.

The Fed and the Treasury are walking down a road that ends with making the price of risk in financial markets, along with the price of liquidity, an administered price.

Politicians will not sit quietly, however, if the Fed attempts to raise rates. Their thinking and the Fed s follows the misguided calculus that if low rates are good for jobs, ultra low rates must be even better.

The Chinese Economy and Fed Policy

The Fed in Denial

Audit the Fed?

Blaming the Fed

The Fed vs. the Financiers

Moreover, those who warn that the Fed might fail to raise interest rates if inflation picks up don t understand that the Fed s culture of inflation targeting is deeply ingrained.

People claim that Greenspan s Fed aggressively pushed interest rates below a natural level.

And, in the United States, where inflation exceeds 2 , the Federal Reserve s benchmark federal funds rate remains at an historic low of 0 0.25 .

Will Fed Tightening Choke Emerging Markets?

The Fed was hardly alone.

As a result, whenever the Fed cuts interest rates, it puts pressure on the whole dollar bloc to follow suit, lest their currencies appreciate as investors seek higher yields.

East Asian countries were told to raise their interest rates, in some cases to 25 , 40 , or higher, causing a rash of defaults. In the current crisis, the US Federal Reserve and the European Central Bank cut interest rates.

However, in the Fed s defense, low interest rates were needed to maintain the expansion.

With its benchmark lending rate at the zero bound, the Fed has embraced a fundamentally different approach in attempting to guide the US economy.

The Fed has signaled that its federal funds rate will remain near 0 , at least as long as unemployment exceeds 6.5 and inflation expectations remain well anchored.