Why Fed rate cuts may be spurring inflation

Nearly half of those surveyed in the Reuters/Zogby poll said they plan to use the money to pay down debt or build up their savings — neither of which will provide the spending boost that Congress and the White House are hoping for. Just 16 percent said they would spend their entire rebate; about as many said they plan to save it all. Nearly one in three said they would pay down debt, while 27 percent said they would spend some and save some.

The uptick in inflation also complicates the Fed’s job for another reason. Though it has a powerful influence on short-term lending rates, it has much less control over the pricing of long-term loans. If investors and savers who park their money in long-term bonds begin to fear that rising inflation will erode the buying power of those investments, they'll begin demanding higher rates in the bond market.

"For the first time in a long time people are starting to question the Fed’s will to fight inflation," said Stanley. "And that kind of leaves the Fed in a tough spot."

Traders bid up interest rates on long-term Treasury bonds after Tuesday’s inflation data were released. Rates had already begun rising after last week’s news that consumer prices also jumped in January. If inflation worries become more widespread, rates could move higher still.

"The market is pricing in a fairly benign inflation environment," said DeQuadros. "And I think it's underestimating the likelihood of high inflation over the next several years as the Fed has moved to this inflationary momentary policy."

If inflation remains strong, and long-term rates move higher, that could undercut the Fed’s efforts to head off an economic slowdown.

"That’s very important in the real economy because most fixed-rate mortgages are set off of longer-term interest rates," said Stanley. "And a lot of the borrowing rates for real people in the economy — be they consumers or businesses — are based as much or more on long-term rates as on short-term rates."

Still, until the housing market recovers and the financial markets calm down, higher inflation probably won’t prompt the central bankers to change course. For the time being, the Fed is in "full risk management mode," according to Diane Swonk, chief economist at Mesirow Financial.

"They are willing to discount these (inflation) numbers — put them on the side and deal with them later — and say the moderation in growth should help moderate inflation," she said. "Whether it does or not, history will tell."

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