The specter of 1937 is weighing on the Fed as it considers how it is going to unwinding the unprecedented monetary stimulus it has imposed.
Recall, in 1937, the Fed faced a recovery with a touch of inflation from the first leg of the Great Depression, but it prematurely tightened monetary policy and was forced to backtrack as the economy fell into into the second leg of the Great Depression.

“I believe that the biggest risk we face today is prematurely engineering restrictive monetary conditions,” one top official said recently. “The U.S. experience during the Great Depression -- in particular, in 1937 -- is a classic example for monetary historians.” A return to growth led the Fed to raise bank reserve requirements, and the government to reduce deficit spending, “the economy dropped back into recession and deflation.” Also, the outlook for growth worldwide is poor. Here, too, there are parallels with 1937. Then, like now, you had a world with an excess supply of goods. The world's growth model, especially for emerging nations, is too much based on exports, but with the goods glut, the problem is, who are you going to export to. In short, the Fed is spooked by the 1937 parallels.

It also has the willies about investors in the secondary markets all running for the exits at the same time. More specifically, it worries about how much money-market mutual funds and exchange- traded funds would be vulnerable to investor runs. The reason is prime money-market funds -- viewed as safe by the public -- have a fixed net-asset value but are vulnerable to investor runs if there is a fall in the market value of their assets. During the 2008 crash, special bailout funds were set aside for the problem. That problem could well occur again if financial markets slip. Similarly, the rapid growth of bond mutual funds and ETFs (exchange traded funds) in recent years means these institutions now hold a much higher fraction of the available stock of less-liquid assets, including high-yield corporate bonds, bank loans and international debt. Bond funds and ETF runs could be a real mess. The Fed worries here too and is twitching.

The Fed is also very much worried about importing disinflation The reason is our monetary policy is about to diverge from other major central banks. With the BoJ suddenly accelerating its QE program, the PBoC cutting rates, and Mario Draghi more than hinting at a potential QE program in the Eurozone, the Fed is becoming increasingly isolated in its plans to begin rate normalization. Even India's RBI, who has kept rates elevated for some time, may begin to ease soon. As a result of this divergence, the US dollar has been on the rise this year. Given the disinflationary pressures around the world, the rising US dollar effectively "imports" disinflation into the US. This is so because because the rising dollar slows exports and increases the imports of cheap foreign goods.This pushes in the same direction as dropping oil and other commodity prices.

The "audit the Fed" movement is another Fed concern. This struggle is not at all about transparency, as some might guess. It is about power and control of the Fed's actions and discretion. The rule boys lurk in the background like Taylor who want to limit the Fed's discretion to act and require they obey mechanical rules. There is a behind the scenes struggle going on here. It worries the Fed.

Now that the economy is beginning to move, as in 1937, the Fed needs to worry about when and if the specter of inflation might arise, especially if growth continues and dishoarding gets going. It could happen quickly. Unwinding will become much harder. The probabilities of either inflation or deflation seem to go up simultaneously.The balancing act becomes finer and the tilt in either direction could be more tricky. The Fed worries here. too.

The Fed has a lot to be twitchy about. Its tools to handle these problems seem to be quite inadequate, looking at the problems. The best it can do, as Yellen suggests, is keep a constant finger on the pulse and have action plans in several directions. Raising or holding rates just doesn't seem to be enough.