This may not come as the biggest piece of news in recent years, but there’s a direct implication here for currency traders; if the Fed is unsure of policy (or rather, as the market perceives the Fed to be unsure about policy), the likelihood of a trend developing in the dollar at this particular time is thereby diminished.

As a trader, the ideal situation is for a trend to exist. Once recognized, the old adage about “the trend being your friend” comes into play because it’s much easier to trade when price has a strong impetuous to move in one direction.

The Fed finds itself at a major crossroads as policymakers wrangle with their desire to normalize monetary policy without killing off a nascent recovery by tightening financial conditions prematurely. Bernanke, a scholar of the Great Depression, is well aware that repeating the mistakes on the mid-1930’s, when too-early monetary tightening led to a recession in 1937 that lasted until the U.S. entered WW ll, could cause the economy to double dip in 2011.

One of the main reasons why Fed policy makers have been able to keep monetary policy so stimulative in the face of an economic recovery is due to the belief that inflation will remain at low levels now and in the medium term. But two new papers from the central bank challenge that outlook. One warns price pressures may rise more quickly than thought in coming years while another raises the question of how well the Fed can divine the future altogether.

According to the Dec. 16th statement, the FOMC “continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” The problem now, is that inflation expectations are not truly “stable” by two important measures.

The first is seen in the steepness of the yield curve, especially in the spread between 2 year and 10 year notes. The 2 year, the most sensitive the Fed rate policy, is currently about 80 basis points above the upper limit of the overnight rate. The second is seen in the spread between nominal Treasuries and Treasury Inflation Protected Securities (TIPS), which guarantee a real (inflation-adjusted) return of principle. That spread, currently at 2.47%, is as high as it was back in July 2008 when oil was hitting $147 per barrel!

It seems clear that market participants are quite worried that the Fed’s ability to rein in inflation and asset bubbles is basically non-existent. Bernanke himself created a firestorm this week when he refused to admit the Fed’s culpability in creating the massive housing bubble, laying the blame more on a lack of bank regulation than anything else. That’s telling investors that it’s Bernanke’s intention to move as slowly as possible when it comes to raising interest rates this time around.

Another problem for the Fed is what to do about its numerous liquidity programs, which are due to roll-off in the first half of 2010. Some officials are coming to the view the program to buy mortgage-backed securities may need to be kept alive longer to aid the economic recovery, and the last FOMC statement specifically said the program could be revived if conditions warranted such a move.

For now, it seems as though currency prices are set to remain somewhat range-bound, with the exception of USD/JPY. That pair figure to gain over time as the Yen resumes its function of acting as the main funding currency for carry trades, and as the new Japanese Finance Minister reverses previous policy in favor of a weaker yen.

Tighter policy is not likely to be taken as a bad sign, as far as investors are concerned. A move to 0.50% in the overnight rate and beyond will be taken as a sign that the Fed has a better handle on asset bubbles and that it believes the recovery is strong to enough to survive without interest rates and extraordinary low levels (i.e. more self-sustaining). China raised rates over 5 months ago (and again this week), and its recovery is doing very well, thank you.