Why Follow the Fed?

The Fed has 2 goals set by Congress. They are maximum employment and stable prices.

If achieved, US economy should be in good conditions where Dollar could remain strong and buying power of average American should continue to grow. 

Why Inflation is Good?

When economy grows, more money needs to be supplied into the market so prices make sense.

Imagine a world where are only 2 one-dollar bills and there are only 2 people living in this wolrd. Each has a dollar.  One person grows wheat, the other raises pigs. 

One day they want to trade. The farmer wants to trade the one dollar for a pig with the other person who in the other hand wants to trade for a bag of wheat. The deal is done. Each still has 1 dollar.

But, both the wheat farmer and the pig farmer continues to grow produce wheat and pigs respectively.

With more products in the market, the original prices of pigs and bags of wheat start to make no sense. How do you price a pig when there are only 2 one-dollar bills in the world while there are a lot of products due to economic growth?

More money is needed so that a pic can remain 1 dollar, so does a bag of wheat.

Back to inflation

Now, there comes the third person so makes smart phones. Both farmers would like to trade for 1 smart phone many of their products, either wheat or pigs.

The smart phone producers think it iOS so easy to make money that he could pay 2 dollars for a pig. 

Inflation happens due to economic growth, when both farmers' product have not changed but their prices have.

Why is it good again?

Inflation triggered by economic growth is normal. Then we should be happy watching one of the Fed's goals, long term inflation of 2%, achieved.

Maximum Employment

When unemployment rates are low, prices should grow, because almost everyone has a job and contribute to the economic growth.

The maximum employment here is the same as both farmers in the previous example have wheat to grow and pigs to raise. If most people work to produce products or provide services. Economic should grow.

Stable prices

When most people are working, what we want to watch next is whether if they are spending. This is the demand side of the force that pushes economy to grow.

Back to the famers' example. When the smart phone maker comes into the world, what would happen of the farmers do not demand any smart phone? They don't buy any.

The smart phones would worth nothing and the smart phone maker would starve to death.

On the other hand, if the farmers would like to buy new phones, they would trade their wheat or pigs for one. In modern day language, they would spend money on smart phones.

What about stable prices?

When people are creating products or services and willing to spend their money, both economic driven forced of supply and demand would bring in the world of better or more products or services. Then more money is needed so that the better products can be priced higher.

If inflation is too high, which is triggered strong economic growth, the Fed could raise interest rates or sell bonds to reduce money supply. 

Consider the previous example of farmers, if the world continued to have only 2 one-dollar bills, the 2 one-dollat can be used to buy more wheat or pigs, right? Because products increase while money supply does not.

Therefore, when the economy is healthy and money supply is reduced, currency value would increase, in other word, US Dollar will grow.

The Fed's Dual Mandates Achieved

This is why watching the Fed's decision on rates or other related things is one important way to assess the health of US economy.

If both maximum employment and stable prices are achieved, this could mean strong Dollar and strong stock market.