The Ben Bernanke Rally

After losing more than 600 points on Monday, the Dow Jones Industrial Average gained more than 400 points Tuesday. The rally was sparked by the statement from the Federal Open Market Committee (FOMC) after their meeting. While it left rates unchanged, the FOMC made several modifications from prior statements. It was the modifications that fueled the rally:

Keeping Interest Rates Low The Fed altered its "extended period" language to now specify "exceptionally low levels for the federal funds rate at least through mid-2013." The Fed is essentially pledging to keep its benchmark interest rate at its record low through this point.

Dissention Three voting members dissented in favor of maintaining the previous 'extended period' language: Richard Fisher, Narayana Kocherlakota and Charles Plosser. This was the first time three FOMC members dissented since 1992.

Fostering Price Stability In its prior statement, the Fed vowed to monitor the economy and act as needed to foster "maximum employment and price stability." The FOMC kept this language in Tuesday's statement, then also emphasized that it discussed a wide array of policy tools to promote a "stronger economic recovery in a context of price stability." In other words, the Fed was trying to signal to the market that it still has tools in its kit.

Slower Economic Recovery Pace The Fed downgraded its assessment of current economic conditions from a "moderate pace, though somewhat slower" to "considerably slower than the committee had expected," with an emphasis on the deterioration in the labor market.

Slower Projected Pace as Well The Fed also downgraded their outlook for the recovery from expecting the pace of recovery to "pick up over coming quarters" to "the committee now expects a somewhat slower pace of recovery," noting "downside risks to the economic outlook have increased."

Causes of Slow Recovery The Fed acknowledged the recent moderation in energy prices but noted temporary factors such as supply chain disruptions associated with the tragic events in Japan, "appear to account for only some of the recent weakness in economic activity."

Inflation After removing language citing the recent rise in inflation, the Fed now expects inflation will continue to "settle" as past energy price increases dissipate.

What It Means These pronouncements signaled to the market that the Fed was now more focused on the weak economy than on inflation, and that it was prepared to take further actions if needed. Having said that, it's important that you don't treat this statement as a guarantee that the Fed will maintain an essentially zero rate policy for another two years. The Fed's future actions will be predicated on what happens to both the rate of unemployment (how much slack there is in the economy) and inflation.

It's also important to note that the Fed still does have some tools in its kit. For example, it could cut the rate it charges at its discount window, currently at 0.75 percent, cut the rate paid on reserve deposits from 0.25 percent to 0 to give banks more incentive to put their cash to work in the economy and not only continue to hold the bonds bought under the quantitative easing programs, but add to those balances.

The FOMC statement is an example of why it's important to understand that while crisis are painful to endure, they do lead to actions taken to counter the problem. Thus, you should be very careful to make sure this is considered before altering your investment plan. You don't want to react to the crisis with panicked selling, only to see actions quickly taken that could lead to a resolution of the problem.

And finally, as a reminder, the Fed's actions don't remove the uncertainty investors have about our elected officials' ability to solve the budget deficit problem causing this crisis. And investors hate uncertainty.

Photo courtesy of Medill DC on Flickr.
More on MoneyWatch:
Implications of the S&P Downgrade How Markets Have Responded to Past Sovereign Downgrades Why the Market Is Behaving Badly Don't Panic: Stock Market Crises Are Normal The Fed Says Rates Likely to Remain Low Through Mid-2013
Three ways I can help you become a wiser investor:

• Follow me on Twitter: http://twitter.com/larryswedroe.
• Read my latest book The Quest for Alpha.
• Download the podcast of my radio show via Buckingham Asset Management's iTunes page.