Why is the Fed so worried about inflation?

John W. Schoen Senior producer • Profile • E-mail

With the economy falling apart, the Federal Reserve is in the middle of a campaign to cut interest rates and help get things moving again. But the Fed is also in charge of keeping a lid on inflation — something that usually requires raising rates. But why, some readers are wondering, is the Fed still worried about inflation in the first place?

Why is the Fed worried about inflation when typically it is caused by too few goods being chased by too many dollars. Isn't the problem now is that inflation is tied to the rise in energy costs — something over which we have little control?
— Larry G., Owens Cross Roads, Ala.

The simple answer is: the Fed is worried about inflation because that’s the Fed’s job. Just because there are no house fires burning at the moment doesn’t mean the folks at fire department can all go home.

And, yes, higher energy costs are a big cause for concern. As you correctly describe it, the problem is that are too few barrels of oil for all the consumers who need it (or want it now to hedge against future price increases) and are willing to pay whatever the last barrel sold for. That's helped push the so-called "core" inflation rate (which leaves out food and energy) above two percent a year — which is higher than where the Fed would like it to be.

Food prices have also been driven up by the huge demand for corn to supply the explosion in production of ethanol since Congress began handing out big ethanol subsidies three years ago.  And since corn is needed for so many other food products — from feed for cattle to corn syrup for soft drinks — those higher corn prices may be spilling over into the wider food economy. It’s far from clear that investing in ethanol is either economical or energy efficient. But with both political parties heavily indebted to the farm lobby and battling for farm belt votes in this year’s elections, it’s unlikely any of them are paying much attention to inflation with they vote to increase farm subsidies.

A lower dollar doesn’t help either. If you go to buy a product made in country with a currency that is getting stronger compared to the dollar, you have to pay higher and higher prices for that product. One reason this impact hasn’t been felt more directly is that much of the stuff we buy is made in China, which has until recently tied its currency closely to the dollar. The slide in the dollar has also boosted oil prices: if you’re a U.S. refiner bidding for oil against someone paying with euros, you have to pay more dollars to keep up.

Then there’s the question of wage inflation — which hasn’t been a real problem for several decades but was one of the biggest causes of the Great Stagflation of the 1970s. For much of the past few decades, workers have gotten more and more productive — thanks in part to the rapid use of technology in the workplace. That’s helped keep a lid on inflation: if you can produce more and more widgets per hour, your boss can afford to give you a raise because the company is selling more widgets.

If those productivity gains slow down or stop — and there are some signs that may be happening — you’re stuck with either stagnant wages or higher labor costs for each widget. The only way to stay in business is to pass along those higher labor costs to your customers, which raises the price of widgets. So far, that’s not happening. But it’s an ever-present threat.

At the moment, the Fed is betting that it can cut interest rates further — and not risk higher inflation. The reason is that if, as now seems apparent, the economy is slowing down, that should tend to cut demand for energy and other commodities and take the pressure off prices for the moment. 

The problem with that approach is that it assumes that if the U.S. economy is slowing so is the rest of the world. That’s been the pattern for most of the recent past. But if emerging economies in Asia and elsewhere continue to push full steam ahead, the demand for commodities and other raw materials — food, energy, steel, etc. — will remains high. And so will the risk of higher inflation.

But it’s just too soon to know how the story will end.

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