Why isn't the Fed worried about inflation?

It's the number that is weighing on investors' minds and consumers' wallets. U.S. inflation in May clocked in at an annual rate of 2.1 percent, a 15-month high, while the benchmark Consumer Price Index rose at its fastest pace in more than a year.

In reality, many goods and services are seeing even bigger price hikes. A pound of ground beef? On average that will run you about $3.85, up more than 16 percent from the $3.31 that it cost a year ago. A gallon of whole milk costs $3.73, up nearly 9 percent, while rents have climbed 3.1 percent. Gas prices, too, are edging up as turmoil in Iraq and Ukraine roils global oil markets, and rents are climbing.

No one enjoys paying more for staples. But it's also important to keep in mind that higher inflation can be a good sign for the U.S. economy, assuming - and here we've arrived at "big if" No. 1 -- it doesn't spiral out of control.

Why good? For one, modestly rising prices indicate a healthier economy and stronger consumer demand, the main reason why the recovery has languished. Especially following a major downturn, prices need to rise so companies can make more money, which allows them to expand and boost hiring.

Inflation can also help borrowers with fixed-rate loans, such as mortgage holders, assuming that - "big if" No. 2 -- wages also rise. If your annual income is growing, after all, your debt effectively shrinks because how much you already owe stays the same.

The Federal Reserve has been fiddling with the monetary dials ever since the Great Recession in hopes of moving inflation toward 2 percent, the rate the central bank considers healthy. For Fed chief Janet Yellen, who last week downplayed recent price hikes as "noise," a little inflation appears to be just what the doctor ordered. And with millions of Americans still unemployed or working less than they'd like, it makes sense to accept slightly higher inflation for a while in the interest of creating jobs.

But even sensible policy may be of cold comfort to people seeing food prices jump when they're just trying to make ends meet. And as long as interest rates remain low, inflation also penalizes savers because prices are rising faster than what they can earn on, say, their bank deposits or retirement savings.

Meanwhile, a prolonged period of inflation running ahead of wages would spell serious trouble for consumers and the wider economy alike. People's "real" income would fall, crimping their purchasing power and restraining the spending that is helping to propel the economy.

Investors view inflation from a slightly different perspective. Their fear is mostly that inflation will accelerate faster than the Fed expects. That would force it to hike interest rates sooner and faster than it has signaled to investors.

Of course, the Fed may turn out to be right in soft-pedaling the risk of inflation. For example, the main reason prices seem to be rising for airfare and hotel room is that more people are traveling, another clue that economic growth is picking up.

But "big if" No. 3 is whether our central bankers can keep inflation dialed in around 2 percent. If not, then a trip to the grocery store or the gas station could end up taking an even bigger bite out of consumers' budgets.

  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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