The Federal Reserve is normally between a rock and a hard place. That’s the nature of its job.

On one hand, it has to keep inflation in check and prevent the economy from overheating. On the other hand, it can’t let the economy cool down to the extent that unemployment gets to be a problem. But the Fed now finds itself in an even tighter squeeze than normal.

Signs point to a stronger U.S. economy. March retail sales rose for the ninth consecutive month — to an all-time high. The economy has added jobs every month for the past six months. Manufacturing activity has expanded for 20 straight months.

The Fed gets some credit for the improvement in the economy. It has kept interest rates near zero. It also instituted a policy of quantitative easing, buying U.S. Treasuries to ensure rates stay low.

But at some point this cheap money party has to end. The question is: When is the Fed going to take away the punch bowl? And what do investors do then?

Commodity prices have been steadily rising. Inflation has begun to be a problem for many of the world’s economies. And the United States is now one of the only countries that hasn’t raised interest rates since the financial crisis.

Even the European Central Bank (ECB), which has some European Union members still struggling with debt problems and sluggish economies, raised its main interest rate a couple of weeks ago.  The central bank felt it needed to raise rates now to combat rising inflation.

And already this year, the central banks in Russia, China, India, Brazil, Peru, Chile, Poland, Thailand, Serbia, Vietnam, Colombia, Nigeria, South Korea — and more — raised their interest rates.

So why doesn’t the U.S. Federal Reserve pull the trigger? 

High unemployment and a fragile housing sector persist
Higher interest rates result in higher borrowing costs for companies and consumers. An increase in rates will likely slow the economy. Although the job picture is improving, unemployment is still problematic. Meanwhile, higher interest rates will also push up mortgage costs; housing is one sector that still needs all the help it can get.

Fiscal tightening just around the corner
U.S. federal budget cuts are coming. While Congress may spend a lot of time bickering about the details, trillions of dollars will eventually be slashed from the budget. (Just yesterday, Standard & Poor’s cut its outlook on U.S. debt to “negative” due to sky-high deficits.)

A more austere budget might be what we need in the long term. But it won’t make things easier in the short term. For instance, England cut its government department budgets by 19% last October. In the fourth quarter of 2010, England actually saw its economy shrink.

Low core inflation… for now
Currently, our core inflation rate (the rate of inflation on goods and services, not including the volatile food and energy groups) is tame. This is allowing the Federal Reserve to maintain its policy of historically low interest rates. But if food and energy prices remain high, then it won’t take long before companies have to pass on these costs to consumers, lifting prices in the core inflation rate.     

I imagine that all these considerations are keeping the Fed up at night.

What should investors do in light of the Fed’s conundrum?
The Fed is biding its time, which means investors have some time to enjoy low rates. But we shouldn’t get too complacent about our low-interest world. Here’s some of the things I am thinking about now, in case we actually see higher inflation and ultimately higher interest rates.

• I want my equity (stock) investments to be in companies that have strong pricing power. I want companies that can pass off higher costs to consumers and maintain their profit margins. This means I want companies that have strong brands, defensive products and services, and/or products and services that are in demand.
   
• I want to be underweight longer maturity, higher quality, fixed-income investments. As interest rates rise, these securities tend to experience more downward price pressure.
   
• I want to increase my holdings in shorter maturity or floating-rate income investments. That way, I won’t be as exposed to rising rates (which make longer-term, lower-yielding investments less attractive).
   
• I want to be overweight in countries that can afford their debt because they are growing their economies rather than countries that have to take a more economically damaging path of austerity. This includes countries like Brazil and Australia.

Action to Take –>  With these simple moves, we’ll be ready if rates begin creeping higher. And if not, then we’ll still be in some of the most attractive investments in any market.

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