Options on the table...

We know that Fed has two mandates (both enacted by congress) which may be broadly defined as insuring market stability to maintain unemployment at its natural rate (whatever that may be) and price stability to ensure that inflation is basically tamed. History also shows us that, at times, the economy may find itself in a position whereby on the one hand we have deteriorating market conditions with unemployment rising and, on the other hand, there are signs of inflationary pressure. Stagflation is usually the term coined to describe an environment in which there is rising inflation combined with stagnant growth and rising unemployment (a prelude to a recession). The U.K. experienced stagflation in the 60's and 70's whilst the U.S. economy was in stagflation during the Carter administration of the 70's. The reason why is so dreaded by governments and central banks is because the main tools at their disposal, namely fiscal and monetary policy become ineffective. This is not to say that the U.S. is in a stagflationary state or that it is heading in that direction (the world has evolved so much and the same principals may not apply anymore). But it is clear that the Fed is having to make a difficult choice between providing market stability and capping inflationary pressure. Right now they are erring on the side of market stability to avert the risk of a recession. We could argue that they are walking a thin line because not only do they need to fine tune between the employment/inflation trade off, but, now that they are leaning towards the side of providing market stability they need to concern themselves between the market stability/moral hazard trade off. Market stability will indeed raise the probability of averting a full blown recession, but it will most likely come at a price in the form of more reckless activity amongst market participants once the stability sets in. These are indeed very challenging times for Bernanke and his crew!