The Fed isn't fooling anyone

But here's why it might not moderate this year: Much of 2007's inflation is a result of soaring food and energy prices. Energy prices at the consumer level climbed 17% in 2007; food prices rose 4.9%. Inflation from these two sources isn't likely to go down if the U.S. economy slows because so much of the demand comes from fast-growing China, India and the Middle East. It would take a slowdown in those economies to cut price increases in the United States. So far, projected decreases in growth are less than 1 percentage point -- or none at all.

But that isn't my big gripe with the Federal Reserve's press release. Maybe the Fed will get the moderating inflation it's looking for in 2008 because we're in an economic slowdown. My gripe is about next year.

What about 2009?

If the Fed's policy of massive interest-rate cuts succeeds in reviving the economy around the end of the year, won't we also see a big increase in inflation? After all, the Fed has been pumping billions in short-term liquidity into the U.S. economy, and other institutions, such as the Federal Home Loan Banks, have been doing the same.

We've seen interest rates drop and drop again in 2007 and early 2008. I think we're likely to see more rate cuts in the next few months as the Federal Reserve tries to stabilize plunging home prices. William Gross, the fixed-income guru at Pimco, says the Fed might take short-term interest rates as low as 2.5% to drive long-term mortgage rates low enough to rescue home prices.

Doesn't all of that -- higher economic growth, a flood of cash into the economy, slashes in interest rates -- create a massive inflationary push in 2009?

Absolutely, unless the Federal Reserve is counting on a global collapse in oil prices or economic growth to reduce global energy inflation and global demand for food and raw materials. But frankly, it's hard to see oil prices falling or the global economy stumbling if the Federal Reserve is able to reverse the decline in U.S. economic growth.

Fed has a bad track record

So, in 2009, we face a big problem and a difficult choice. We can ignore rising inflation because the U.S. economic recovery is still fragile, which risks letting inflation build momentum and makes it harder to fight in the future. Or we can raise interest rates to fight inflation and risk stalling the U.S. economic recovery.

The Fed doesn't have a great track record at that kind of decision. In the aftermath of the stock market bubble in 2000, Alan Greenspan's Federal Reserve took interest rates down to 1% to stabilize the financial markets and the economy. But then it left interest rates too low for too long, and that created the housing-market bubble. Will the Bernanke Fed do any better at handling the very tricky turn from an easy-money policy that supports the economy to a monetary tightening that prevents higher inflation and a new asset-market bubble?

I doubt it. But that's the huge challenge that lies just ahead for the Federal Reserve. Hand waving over how inflation will moderate in the coming quarters won't make it go away as the problems of 2009 loom. And such hand waving really doesn't fool anybody who has been paying attention through the past decade as the Federal Reserve has bounced from fixing one bubble to inflating the next.

Here they go again.

Continued: Developments on a past column

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