Last Wednesday, during the snowstorm that shut down Washington, something odd happened. Even though the testimony of Fed Chief Ben Bernanke was cancelled, the Fed still released his planned comments anyway, which laid out their tentative plans to remove stimulus from the economy, beginning with an increase in the discount rate. This Thursday, the Fed, as promised, raised that rate by a quarter-point. This is the rate charged to banks needing quick cash. At one time last year, the Fed had issued over $500 billion in these short term loans. Today, it is less than $30 billion and relatively unimportant. So, why did the Fed do this, since so few banks will be affected?

One reason is to flatten the yield curve a little. The difference between two-year and ten-year Treasury rates is a historically high 2.9 percent. This is a subsidy to the banks, who can borrow very cheaply, while lending money out expensively, creating a fat margin of profit. Apparently, the Fed believes the banking system no longer needs the subsidy, which would be a good thing.

Another reason is to encourage China to continue buying our debt. Their holdings of our Treasury debt has stabilized, and we need them to continue buying confidently. Since our bonds are denominated in dollars, China was losing money by holding dollars when the dollar was depreciating. Yesterday’s action is very bullish on the dollar and should help the Treasury to sell their bonds.

More importantly, inflation is much harder to control once inflationary expectations have been created. Many analysts, such as myself, believe inflation is inevitable and maybe even desirable. To keep that inflationary expectation from growing, the Fed last week laid out their plan to curb inflation and implemented the first step this week. They want to demonstrate their conviction to combat inflation, and I wish them well.

The next step is likely to be an increase in the interest rate that the Fed pays on bank reserves it holds at the Fed, which is a more important step. A big increase would encourage banks to leave money in reserve at the Fed and not to lend money into the economy, which would further dampen inflation expectations. Logically, the next step would be taken when unemployment is not such a problem, but inflationary expectations would have already hardened by that point and would be too late. When that happens, it is time to sell any long term bonds, quickly.

While this was clearly a warning shot over the bow, I don’t think they are ready to dampen the economy anytime soon. While I think inflation is still the most likely and most desirable outcome, the Fed has reminded us that they do indeed have the power to prevent it. (Think: Paul Volcker) But, do you think they will? . . . in this political environment . . . with stated unemployment at 9.7% and under-employment at 17% . . . when core CPI inflation is only 1.6% . . . I don’t think so!