Bernanke Holds His Ground

If you think your job presents daily challenges, take a second to think about Ben Bernanke's predicament. Inflation is blowing through the roof, yet financial markets remain hanging on by their fingernails. The yin and yang of economic forces must haunt the poor guy at night.

On Wednesday, as expected, the Federal Reserve left the federal funds rate steady at 2%. The meat of the Fed's challenge can be summed up in a few statements from its press release:

Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters ... in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high.

If there's ever been a double-edged sword of economic policy, current conditions likely take the cake. In a sense, there's no perfect solution Bernanke can implement; his options are limited to curtailing the damage and choosing between the lesser of two evils. I bet quitting his cushy job at Princeton is looking more and more regrettable as the days pass.

So, what does the Fed's interest rate policy mean for you? More than you might think. With current market conditions held hostage by sluggish debt markets and consumer angst over inflation, interest rates now hold more clout than they have in a while.

Here are a couple of byproducts of higher and lower interest rates.

Higher rates
The daily headlines concerning inflation's wrath hasn't seemed to spare anyone lately. Earlier this week, Dow Chemical (NYSE:DOW) announced that it will raise prices by as much as 25% -- on top of June's 20% hike -- in an attempt to combat the swelling cost of oil-based products. When two such radical moves come from a sturdy, bellwether company like Dow in less than a month, it's hard to describe the climate as anything but inflationary warfare.

Higher interest rates typically quell inflation because lending becomes more costly, which chokes off spending, which eventually saps demand for products like oil and grains, and hence brings prices down. Still with me? Good, because there's more. Higher interest rates also strengthen the dollar, which could help alleviate oil's never-ending run because so much of our oil gets imported from foreign countries. Who else might benefit from a stronger dollar? Companies that rely on cheap imported goods, like Wal-Mart (NYSE:WMT) and Costco (NYSE:COST).

Lower rates
The flip side of the coin is that two of the biggest forces pulling the economy down -- banks and housing -- need lower rates like their lives depend on it. Mainly because, well, many of their lives actually do.

Years of leveraging to the moon with debt products that contained who-knows-what has left crowds of commercial banks, investment banks, and mortgage lenders scrambling to unload unwanted assets. Citigroup (NYSE:C) announced plans to cut $400 billion of assets, Lehman Brothers (NYSE:LEH) recently shed $130 billion, and even healthy Goldman Sachs (NYSE:GS) has ditched tens of billions' worth of unwanted loan exposure.

But if interest rates don't stay low, what little progress has been made to free up fearful credit markets can quickly disappear, sending everything from car loans and credit cards to mortgages and municipals into further disarray.

Hence Bernanke's nightmare: Going too far in either direction will send part of the economy into shambles, yet standing still -- as he did on Wednesday -- might let both issues fester. In reality, each side of the coin is as serious as the other in its own way. So what should Bernanke focus on: inflation, or the credit market? Truth is, he has to worry about both, but can't readily combat both at the same time.

What a mess.

For related Foolishness:

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