When Lehman Brothers announced bankruptcy and the economy went into a recession, the Fed did its best to avoid a 1930s like scenario. It pumped a lot of money into the economy to maintain liquidity and help businesses survive.
Now that the economy is recovering, the Fed will have to act in the opposite direction in order to control the surplus money in the system or we’ll have to face a period of high inflation. Several economists have emphasized the need for the Fed to act before it is too late.
Controlling flow of credit
It will soon become important to raise interest rates to prevent individuals and companies from taking too much debt. The Fed brought the benchmark rate to near zero levels during the recession, but the rate was raised to 75 bps in February. However, this is still quite low when you look at the long term trend of Fed rates.
Fed Chairman, Ben Bernanke, recently told the Congress that the Fed is in no hurry to raise rates, as the inflation pressure is not serious right now, while unemployment is still quite high. But most analysts believe that a rate hike could be on the cards, unless the unemployment rate worsens. The inflation situation could change very rapidly, and a steep increase in prices could make things worse for those who are looking for a job.
Tightening the availability of money
It is important to that the availability of cash is tightened. This can be easily done by increasing interest on the Fed Funds. However, merely raising policy rates may have negative effects, as was seen during the 1930s. To deal with this problem, the Fed has decided to pay interest on both required and excess reserves. This way, the Fed can maintain liquidity in the system and still stop the money from going into circulation, as banks are encouraged to maintain high reserves instead of giving away risky loans.
Although, the Fed has several other options to reduce the amount of money in circulation, such as an open market sale of securities, none of these measures will go down well with either businesses or individuals. The most difficult decision will be to increase interest rates. People have become used to low interest rates, and the most severe impact of a rate hike would be seen on demand in the housing market.