Is the Fed Fueling the Inflation Fire?

By Jennifer Yousfi
Managing Editor

With six rate cuts in the past seven months, the U.S. Federal Reserve has focused its efforts on a slowing economy, while placing inflationary worries on the back burner.

But as Chairman Ben S. Bernanke and the rest of the Board of Governors move further down this path, some experts believe it's becoming increasingly clear the central bank isn't just ignoring inflation. It might just be creating it.

"Every cut the Fed makes is adding jet fuel to a fire that's already burning," Money Morning Investment Director Keith Fitz-Gerald said in a telephone interview yesterday.

On Tuesday, central bank policymakers cut the benchmark Federal Funds rate by a less-than-expected three quarters of a percentage point, dropping it down to 2.25%. Many analysts had been expecting a reduction of a percentage point – or even more – because such events as last week's near-collapse and subsequent Fed-led bailout of U.S. investment bank Bear Stearns Cos. Inc. (BSC) was fueling fears that the U.S. financial system was ready to freeze up.

While the policymaking Federal Open Market Committee (FOMC) made it clear that inflation has grown as a concern, it still says that economic worries remain the biggest problem and emphasized that it was ready to cut rates again if the U.S. economy continued to show signs of distress.

But economic weakness may not be the only sign of distress the central bank needs to watch for: That "burning fire" Fitz-Gerald references is inflation – and it's been burning brightly for some time now.

Consumer price inflation was 4.1% in 2007, its highest annual rate in 17 years. The producer price index rose 7.4%, its biggest jump since 1981.

And reports released in the New Year aren't much better. Everyone's feeling the pinch – from the business owner to the consumer. The Producer Price Index (PPI), which measures inflationary pressures from the perspective of sellers, rose 0.3% in February. That increase follows a 1% increase in January.

The Consumer Price Index (CPI) rose 0.4% in January, while import prices increased 1.7%. The data for February has yet to be released, but it's unlikely inflation has gone down, as the greenback continues to weaken.

"Every dollar the Fed prints makes every other dollar out there worth less," says Money Morning's Fitz-Gerald. "That's the classic definition of inflation."

A Differing View

But not everyone feels the Fed is responsible for the recent surge in prices. Dr. Joel L. Naroff, head of Naroff Economic Advisors is firmly in the opposite camp.

"The Fed is not fueling inflation," Naroff told Money Morning in a telephone interview yesterday (Wednesday). "The Fed can only control inflation created by excess demand."

And Naroff believes that the current price surge in oil, food, and other commodities has nothing to do with consumer demand.

Oil has reached recent highs of $110 a barrel, despite a slowing economy and significantly higher inventories.

"That's not an issue of demand," Naroff said. "That's speculation."

As for food, Naroff believes a U.S. Congress hungry for ethanol has touched off an inflationary speculative frenzy in certain parts of the commodity market. The price of corn has skyrocketed and the higher cost is showing up in every food product with a corn-based ingredient. Corn's price spike is causing profit-seeking farmers to plant more of the yellow grain, forgoing the planting of other grains, which in turn boosts the prices of those grains as supply declines.

Less grain at higher prices is pushing up feed costs for livestock farmers, who in turn are passing those increases along to the consumers in the form of higher meat prices.

"What's the Fed supposed to do?" Naroff asked. "Raise interest rates until people start eating less?"

As for the other commodities, Naroff blames the current distrust in the financial markets. Investors are shunning what they perceive to be risky financial assets in search of a safe haven. And for now, that safe haven is commodities.

When so many investors try to squeeze through a narrow door all at once, the result is higher prices. Again, that's not something the Fed has caused, Naroff contends.

A Crisis of Confidence

Whether you think the Fed is adding fuel to the inflation fire or not, it's a fact that lower interest rates depress the value of the U.S. dollar. And that means domestic spending power is reduced.

The Fed is hoping lower interest rates will increase liquidity in the markets and boost consumer spending. But there's a major flaw in that plan, says Fitz-Gerald.

"The Fed is hoping by providing liquidity, they will stimulate spending," Fitz-Gerald said. "It's straight out of the Chicago School, but that's assuming there are healthy financial institutions to help spread that liquidity around."

And Fitz-Gerald feels our financial institutions are anything but healthy right now.

"To be fair, I can sympathize and understand what Bernanke is trying to do," Fitz-Gerald said. "But the problem is what he's trying to do presumes the credit markets are operating in a normal fashion. And they're anything but normal right now."

And on that point, Naroff agrees. Until confidence returns to the financial markets and banks begin to trust each other again, investors will continue to seek alternative investments, putting upward pressure on commodities prices and fueling inflation.

News and Related Story Links:

• The Washington Post:
  Behind Cheaper Credit, Inflation Fears Loom

• Forbes:
  Memo To The Fed: Stop Those Rate Cuts

• CNNMoney.com:
  The Fed may be done – Get over it

• Money Morning:
  Dear Ben: To Save the U.S. Economy, Here Are the Moves You Need to Make Now

• Money Morning:
  With Latest Rate Cut, Fed Tries to Find Balance Between Recession and Inflation