The Federal Reserve's high-stakes "roll of the dice" to keep deflation at bay, while also attempting to stimulate the American economy (and generate a wee bit of inflation) remains largely on track. Where we go from here remains the subject of intense debate as the Fed continues to operate in uncharted waters.

U.S. consumer prices (the CPI) rose 1.5 percent during 2010, down from the prior year's 2.7 percent rise and below the 2.5 percent average annual inflation increase during the period 2000-2009. Even so, the latest 12-month rise in November was just 1.1 percent.

In the eyes of the Fed, the more critical "core rate" of inflation — which excludes food and energy costs — rose only 0.8 percent during 2010, the smallest increase on record. The 0.8 percent core inflation rise last year compared to 1.8 percent increases during both 2008 and 2009. As some Fed critics would suggest, the "core" inflation measure is particularly important for those people who don't eat or drive.

Inflation or deflation?

The Fed continues to walk a tightrope between inflation and deflation. I would argue that during the past two years, the Fed has been more concerned about the latter. While declining prices may sound like a good thing to some, falling prices are soon followed by declining incomes.

History tells us that deflation is a more challenging scourge to deal with than is inflation. Just ask the Japanese, who dealt with eight consecutive years of deflation during the 1990s after that nation's asset and housing bubble burst … a nation that is now dealing with deflation again … a nation that saw the "lost decade" of the 1990s followed by much the same during the next decade.

The QEs

The Fed, under the leadership of its Chair Ben Bernanke, continues to conduct unprecedented monetary policy, with initiatives during the past three years that are nowhere to be found in their operating manual. The latest of these initiatives is a $600,000,000,000 second round of purchases of U.S. Treasury securities, with the intent of providing stimulus to the American economy.

The Fed's first foray into the unknown was a massive purchase of $1,700,000,000,000 in U.S. Treasury securities and mortgage-backed securities between mid-2009 and early 2010. The Fed's desire to push long-term interest rates lower was ultimately successful. The program was referred to as "quantitative easing."

Thirty-year fixed-rate conventional mortgages eventually fell to 50-year lows near 4.20 percent. Various signs that the U.S. economic expansion was weakening by mid-year 2010 also led to the decline in long-term interest rates.

The second program, affectionately referred to as "quantitative easing 2," or QE2, has been less successful. Long-term interest rates have actually risen by 5/8 percent to 7/8 percent, depending on the type of security. In this case, rates rose because of investor anxiety about the longer-term inflationary implications of a second QE program, as well as brighter prospects for U.S. economic growth. Rumors of a third QE program later on are primarily met with investor concern at this time.

All that income!

One by-product of the Fed's aggressive bond purchase programs has been a major rise in the Fed's "earnings" from bond interest payments. What happens to these earnings? These funds are routinely funneled back to you and me (the taxpayer) via regular transfers to the U.S. Treasury Department. The Fed earned a record $80.9 billion during 2010, with $78.4 billion transferred to the U.S. Treasury. The transfer was up 70 percent from a year earlier.

The Fed has both supporters and critics regarding these enormous bond purchase programs. The Fed has essentially tripled the size of its balance sheet from roughly $800 billion to $2.4 trillion during the past 2-3 years — all with newly created money — used to purchase the securities.

The Fed's aggressive purchases of U.S. Treasury securities do help the U.S. Treasury find buyers for the massive issuance of debt required to finance enormous U.S. budget deficits. Bonds bought by the Fed don't have to find buyers among the Chinese, the Japanese, OPEC nations and other significant buyers of U.S. Treasury bills, notes and bonds.

However, "Wall Street" is worried about how difficult it will be in coming years when the Fed decides to reverse the money creation process, sell securities and return its balance sheet to more traditional levels. What will be the impact upon long-term interest rates at that time? How will the Fed respond to expected intense criticism from the Congress about reversing current aggressive monetary policy when the unemployment rate will still very likely be uncomfortably high?

Fed critics

The Federal Reserve has no shortage of critics as to its very existence. Some of the most conservative members of the new Congress will sponsor congressional hearings as to whether the Fed should be eliminated. Others will call for strict audits of Federal Reserve activities.

Still others will insist that the Congress should put the Fed on a tight rein, with the Congress then making all critical monetary decisions. I can't think of anything more frightening than letting the U.S. Congress — already responsible for the budget deficit we run of $160,000,000 every 60 MINUTES — also be given control over monetary policy!

The Federal Reserve plays a vital role in the American economy. Yes, this Fed is perhaps due criticism for various missteps in recent years. Yes, the Fed when under Alan Greenspan arguably made a few blunders.

Prior to the Fed's creation in 1913, this nation routinely had depressions every 20 years or so. There was no mechanism to provide additional monetary stimulus in times of need. It was this reality that led to the Fed's creation by the U.S. Congress.

The one and only

The Fed has a unique ability that all other institutions lack: the ability to create money. With such power comes awesome responsibility.

The Federal Reserve — or any nation's central bank — must earn and maintain the confidence of investors that it will use this power wisely. Without confidence, a central bank has nothing.

Too many central banks around the globe have, at times, created too much money to fund government, such as leading to hyper-inflation in Germany following both world wars. Numerous Latin American and African nations have also destroyed the value of their currencies and severely damaged their economies.

There are three major "governmental" bodies in the nation's capital that directly impact the economy: the executive branch, which includes the president; the Congress; and the Federal Reserve. I would argue the body which enjoys the most credibility with U.S. financial markets, with U.S. financial market players and with global financial markets and their respective players is the Federal Reserve.

Jeff Thredgold is chief economist for Zions Bank and founder of Thredgold Economic Associates, a professional speaking and economic consulting firm. Visit