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Why Fed rate cuts may be spurring inflation

With the economy slowing and the housing market stuck in reverse, Tuesday’s report of a surge in wholesale inflation last month was not good news for the Federal Reserve.
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With the economy slowing and the housing market stuck in reverse, Tuesday’s report of a surge in wholesale inflation last month was not good news for the Federal Reserve.

The problem: Central bankers now find themselves between a rock and a hard place in trying to meet their dual goal of setting interest rates low enough to get the economy moving again while also keeping them high enough to keep prices in check.

The Fed can’t do both. But given the ongoing turmoil in the capital markets — and the risk of a credit crunch that could do even more damage to the fragile economy — Fed watchers say inflation-fighting is taking a back seat.

"Right now they feel the greater risk to the economy spills over from the housing slump," said Joshua Feinman, chief economist at Deutsche Bank Asset Management. "They are still going to err on the side of providing more insurance against downside risk to the economy."

The Fed's latest inflation forecast, issued last week, projects "core" inflation of up to 2.2 percent this year, dropping down into the Fed's preferred range of below 2 percent next year.

A slowing economy is supposed to help keep inflation in check, as weaker demand takes some pressure off prices. Some economists note that, with the economic downturn still in its early innings, it may simply take awhile longer for the slowdown to begin easing inflation pressures.

But there are forces at work driving prices higher that may persist even once the impact of the slowdown is fully felt. Oil prices are being driven higher, in part, because oil producers are having trouble finding new reserves fast enough to keep up with the growth in global demand and the depletion of older oilfields.

Food prices have also been moving higher, in part, because of those higher energy costs and the need to find alternatives to oil, according to Stephen Stanley, chief economist at RBS Greenwich Capital.

"The whole ethanol craze is behind a lot of the food inflation in the sense that it's driven up corn prices and increased the demand for crop space because people want to grow crops to make ethanol," he said.

Food and energy prices have been tracking higher for some time, but the data for January showed a more worrisome trend: Those higher costs seem to be working their way through the economy faster than expected. The prices increases were broad-based, a sign that companies can no longer absorb the higher costs of producing goods and services, economists say.

There are also signs that the Fed’s shift to an easy-money policy last year — designed to revive the economy and calm the credit markets — may be adding fuel to the inflation fire. By pumping more dollars into the economy to spur growth, the Fed has been weakening the dollar, according to Conrad DeQuadros, a senior economist at Bear Stearns.

"As result of that (easing) the value of the dollar has fallen," he said. "And that’s making the cost of goods that we get from abroad more expensive."

Consumers are already feeling pinched and tell pollsters they’re hunkering down as the economy slows. A majority told a recent Reuters/Zogby poll that they expect a recession in the next 12 months. That was the first time since the poll began asking the question last September that a majority said they expect recession.

Those recession fears may take some of the wind out of the sails of the government’s fiscal stimulus plan — which will begin mailing tax rebates in a few months to try to get the economy moving again.

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."