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.

Federal Reserve Chairman Ben Bernanke.
Mary Altaffer
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.

'Pious Statements'

Dow Chemical on Tuesday announced its second major price increase in a month, while home improvement retailer Lowe's said it is seeing unprecedented price increases from its suppliers, with both companies citing transportation costs as the main reason for the cost surges.

Dow CEO Andrew Liveris told CNBC, though, that he doesn't think monetary policy will be a big factor in lessening the load of fuel costs.

"I think many people have said on this whole energy thing it's really supply and demand and I fully agree with that," Liveris said. "What we're talking about here is fundamental supply and fundamental demand. Anything monetary on top of that right now does add a factor but, frankly ... I would not give that much weight."

But those in favor of aggressive rate-raising see the squeeze oil is putting on the economy as precisely the reason to move the rates higher regardless of what effect it would have on energy costs. Meltzer wants the fed funds rate moved from 2.0 percent up to 4.0 percent to stay in line nominally with an approximately 4.0 percent rate of inflation, to make the real rate zero percent.

So what does he actually expect the Fed to do during its meeting this week?

"Nothing," he says. "They'll make some pious statements." But Meltzer adds he "wouldn't bet a wooden nickel" on the Fed raising rates.

Nor would many others, as the fed fund futures are not anticipating a rate increase at least until later in the year.

Elmendorf says the Fed instead will focus this year on preventing a wage-price spiral in which income tries to keep up with expenses, which can result in stagflation.

"I don't expect them to raise rates this year. Actually I think they will wait until the beginning of next year," he says. "They will say in their statement that they're worried about inflation. My guess is they will say the economy is slow enough and inflation is slowing and that will let the Fed wait until next year to raise rates."

But if Farrell had his way, there would be at least two rate hikes before the year is out.

"What we need to do is 1) destroy demand, which high prices (are) starting to do; 2) defend the dollar to contain the rate of inflation," he said. "What we need is some action, we need some leadership."