Good Inflation, Bad Inflation: The Fed's Dilemma

Average Americans who shop at the grocery store, fill up their tanks at the gas pump and pay monthly utility bills have to be shaking their heads in confusion amid the growing debate over inflation.

On the surface, it doesn’t seem confusing: if the costs of goods and services are moving higher, as they are in many sectors of the economy that directly affect consumers, then inflation is a concern.

Consider the following data released this week by the Department of Labor: consumer prices jumped 0.4% in May over April, the largest increase in over a year, and the broader consumer-price index rose 2.1% from a year ago, which is higher than the Federal Reserve’s 2% target rate for inflation.

Economists may have been taken by surprise (they had predicted a smaller increase), but consumer probably weren’t.

Anyone who’s been to the grocery store recently knows how sharply prices have risen, especially for meat and poultry, staples of most households’ dinner menus.

More broadly, the Labor Department reported that “the indexes for shelter, electricity, food, airline fares, and gasoline were among those that contributed” to the unexpected increase in consumer prices. The food index posted its largest increase since August 2011, the government said, and increases in the electricity and gasoline indexes contributed to a 0.9% rise in the energy index.

Food Isn’t Non-Discretionary

As any consumer knows, the costs cited most prominently by the government are deemed non-discretionary spending in virtually every household. We’re not talking about the price of a jet ski or a weekend in Las Vegas. Groceries have to be purchased if the family is going to eat. The gas tank has to be filled if mom and dad are going to get to work. The rent has to be paid if the family is to remain in its home. Same with the energy bill if the lights are going to stay on. And so on.

The problem is that the areas where prices are currently moving higher, primarily food and energy, are considered too volatile and susceptible to temporary events such as the weather or political strife overseas to prompt the Federal Reserve into action.

One of the Fed’s dual mandates is price stability, or keeping a lid on inflation. (The other is full employment.) In normal times, the Fed could point to a harsh winter, a drought in California and upheaval in the Middle East and say no long-term policy actions are needed to rein in inflation.

But these are hardly normal times. The Fed is in the early stages of winding down its unprecedented accommodative policies initiated to ward off an outright depression in the wake of the 2008 financial crisis.

Part of that unwinding process will include raising interest rates from the historically low, near-zero range where they’ve been held for the last five and half years.

How Much Inflation is a Good Thing?

Inflation hawks, including some vocal members of the central bank’s policy-setting Federal Open Market Committee, have long argued that creating easy money through the Fed’s asset purchasing program and low interest rates will one day result in runaway inflation. Pumping almost unlimited amounts of cash into the economy will eventually result in higher prices, they say.

That argument has grown considerably stronger with the recent inflationary data.

Add to that the recent strengthening of the U.S. labor markets, which should tighten demand for jobs and push up wages, and a jump in inflation is inevitable. The question is how big a jump.

The part that’s confusing to most people is that the Fed wants some inflation -- a 2% annual rate to be specific -- because it means the economy is humming along nicely, creating jobs, lifting wages and increasing consumers’ ability to spend. All of which generates demand for goods and spurs economic growth.

Despite the jump in high-profile consumer prices, prices overall haven’t risen enough to convince the Fed that the economy is humming along nicely. So a majority of Fed policy makers, known as inflation doves, are vowing to keep interest rates low for the foreseeable future, or at least until the inflation rate approaches that 2% target and unemployment falls nearly another full percentage point.

Fed Chair Janet Yellen, the most prominent and influential of the Fed’s doves, on Wednesday disagreed with a suggestion that Fed is ignoring inflationary red flags, referring to the recent jump in consumer prices as “noise” in the data. (“Noise” is economist jargon for a temporary blip.)

A Giant Balancing Act

The Fed has committed to a strategy of gradually unwinding its stimulus programs, tapering asset purchases by $10 billion per month and holding off on raising interest rates until the economy is strong enough to stand on its own, probably sometime in mid-2015.

It’s giant balancing act, one that will significantly impact long-term lending rates, home values and corporate earnings. If the Fed pulls back too soon the fragile economic recovery could falter – again. But if the Fed waits too long to pull back, the risks include runaway inflation and asset bubbles.

Meanwhile, the Fed’s cosmic dilemma is already hitting consumers where it hurts the most – their wallets.