As oil and food prices rise, so will inflation. The conventional view is that the Federal Reserve would have to halt its monetary stimulus efforts if inflation begin to rise rapidly. But that view might not encompass the big picture. It's possible that skyrocketing oil prices could actually cause the Fed to engage in a third round of quantitative easing.
First, let's consider the conventional wisdom. The Fed attempts to stimulate the economy by putting more money in the system. Under normal circumstances, this would cause inflation. If more dollars are in economy, then the purchasing power of a dollar should decline. But during a slowdown, there may be so much money kept out of the economy that the additional dollars replace those taken out so that prices do not rise -- at least not in the short-term. Eventually, if that stimulus isn't removed, inflation will result.
During most recessions, inflation remains low, and deflationary pressures grow. As a result, temporary monetary stimulus can often be provided without causing a high rate of inflation. But what happens if inflation is ramping up? Shouldn't that shut down the printing presses?
You might think this logic would apply now. For starters, some people believe that the Fed's aggressive efforts have been part of the reason why oil and food prices have increased so much over the past six months. In fact, inflation occurring at too low a rate was one of the reasons why the Fed said its second round of quantitative easing was necessary.
If prices start rising more rapidly, then shouldn't that preclude additional intervention with a third round of monetary stimulus? There are two reasons why it might not.
First, the Fed cares mostly about so-called "core" inflation, not overall inflation. Core inflation excludes energy and food prices, which are precisely the ones that have climbed in recent months. We don't have inflation data for February yet, but the Consumer Price Index rose by 0.4% in January. Most of that increase was due to food and energy, however. If you take them out of the equation, then prices only increased by 0.2%, which is still relatively benign inflation.
Second, if oil prices continue to soar upward, then this could threaten the recovery. If the economy begins to slow as a result, this provides additional rationale for the Fed to provide more monetary stimulus. A decline in business activity due to higher energy prices could slow hiring or even cause firms to resume layoffs. That puts pressure on the Fed to activate additional quantitative easing to comply with its full employment mandate.
This second possibility was actually mentioned this week by Atlanta Fed President Dennis Lockhart. Chris Isidore at CNN Money reports (h/t Calculated Risk) that Lockhart said at a conference on Monday:
If [the rising price of oil] plays through to the broad economy in a way that portends a recession, I would take a position we would respond with more accommodation.
Currently, Lockhart is not a voting member of the Federal Open Market Committee that conducts monetary policy. In his opinion, however, if oil prices approach $150 per barrel, then he would be concerned.
So don't count out the Fed just yet. Rising oil and food prices won't necessarily keep the central bankers at bay. Instead, higher inflation that's driven by energy and food could actually cause even more monetary stimulus.