If Oil Is Causing Inflation, What Can Fed Really Do?

The Federal Reserve finds itself in an uncomfortable situation: Staring down the barrel of inflation with limited options on what it can do to stop the bullet.

On previous occasions, with normal market dynamics in play, a shove upward on interest rates would strengthen the dollar, give Americans more purchasing power, and send down the prices of goods and services.

Mary Altaffer / AP Federal Reserve Chairman Ben Bernanke.

But these aren't normal times, thanks primarily to one factor: Oil.

The price of oil no longer is driven solely by what Americans will pay for it but by a global demand beyond the Fed's reach. The end result is that the central bank has found itself in a position where it is highly limited in what it can do to control inflation.

"The Fed can't do anything about supply shocks," says Doug Elmendorf, a senior fellow at the Brookings Institution. "What it can do is let the economy grow more slowly for a while."

In Elmendorf's assessment, keeping rates steady is about the only strategy the central bank can do to control inflation generated primarily by skyrocketing oil prices, while also tending to an economy teetering on recession.

But some Fed critics think pushing up interest rates could have a profound impact on oil prices and hope that the central bank chooses not to stay on the sidelines but gets proactive in heading off inflation. The Fed, which began a two-day policy meeting Tuesday, is widely expected to leave rates unchanged, although speculation is growing that a rate hike could come as soon as August.

"I think it's very critical that we send a signal to the world that we care about inflation, we care about the dollar," Vince Farrell, a principal in Scottsman Capital and proponent for raising rates, said on CNBC. "Once that inflation genie gets out of the bottle it's very hard to get back in."

Farrell believes a stronger dollar would have an appreciable impact on the price of oil, a point disputed by some who say surging global demand and speculators are having a far greater impact on energy costs in the open market.

Farrell says that if the dollar was trading evenly with the euro, that would send oil down to $80 a barrel, about 40 percent less than its current eye-popping price.

But even if a stronger dollar would have only a marginal impact on oil, many believe the Fed at least can contain the damage energy inflation is having on the rest of the economy.

"The Fed has made a mistake, a big one, in fact a number of mistakes, and the only thing it can do now is begin to correct them," says Allan H. Meltzer, a Fed expert at Carnegie Mellon University. "It overreacted to the housing slump, it overestimated the loss in jobs, it underestimated the inflation effect, so it should know by now that for the millionth time its forecast was not very good. It should aim at a low level of inflation for the short term."

Meltzer also backs a rate increase even mindful of the havoc it might trigger for the rest of the economy.

"In the near term there would be screams of outrage from Congress, from the stock market and so forth," he says. "But that's why we're supposed to have an independent Fed. They're supposed to be governed by the interest of the public and they often forget that and they're forgetting it now."

If there were the "screams of outrage" to which Meltzer refers they would have to compete with similar howls coming now from not only consumers but also heads of business whose corporate profits are being eaten up by spiraling energy costs.

CONTINUED : 'Pious Statements'

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