Inflation is too high and getting higher.  The consumer price index is running, as some headlines put it, "hotter than expected."  The headline rate was up 1.1% for June, the largest one-month increase in 26 years.  Once again, the largest gains were in energy and food.  The Core CPI, which excludes those volatile components, was up 0.3%, which is a 3.6% annual rate without compounding.

June's Producer Price Index was even worse at the headline level, although producer prices are unlikely to be fully reflected in future consumer prices given that labor and other factors are embedded in consumer prices.  The headline PPI was up 1.8% in June, while the Core PPI was only up 0.2%.

The FOMC recognizes the seriousness of the inflation problem, but, at the moment, it has more urgent problems to deal with.  The first is the weak economy, which has been losing payroll jobs at a rate of 91,000 per month for the past 6 months.  The second, even more urgent, problem is the continued fragility in the credit markets, as evidenced most recently by concerns over Fannie Mae and Freddy Mac.  The third problem is the weak dollar.  Some people would include oil as an additional separate policy concern, but the price of oil is determined in international markets, and I doubt it can impacted significantly by Federal Reserve actions.  

Financial talking heads made much of the Fed having three target goals and only one policy tool.  I would argue that it's really only two to one, even though that is bad enough. The reason is that actions to restore financial stability would likely also help stabilize or stimulate the weak economy; therefore, those two goals aren't in conflict to my mind.

So, the Fed has to decide whether to place priority on financial markets and a weak economy on the one hand or inflation and the weak dollar on the other hand.  In his semi-annual testimony and report to Congress earlier this week, Chairman Bernanke indicated that he currently has to give priority to the former, especially the stability of financial markets.  He restated the FOMC's continued belief that, as economic weakness continues, the slack in the economy will help pull inflation back down without direct Fed action.  He also believes that oil and other commodity prices are in bubbles that are likely to burst of their own accord.  I agree, but I acknowledge that it's only a hunch and a hope.

There is a school of thought on financial TV that the Fed's first priority should be to raise the target Federal Funds rate at least once, and soon, which they expect to result immediately in a stronger dollar, which in turn would strengthen the economy.  I will examine that assertion in a separate blog. Meanwhile, to raise interest rates in the midst of the current financial turmoil and fragile economy is, in my opinion, too risky an experiment to try. 

With all we have going on right now, I doubt that a quarter-point narrowing of the interest rate differential between the U.S. and the Euro zone, which is the relevant comparison, would make much difference in the exchange rate.  The dollar's weakness is primary with the Euro.  I would even quibble that the problem is more a too-strong Euro than a too-weak dollar.

As I've said before, but it bears repeating, I want a stronger dollar, but one that is made stronger by exports growing faster than imports resulting in a narrowing of our trade deficit.  Dollar strengthening through export-led growth does not put the domestic economy at risk as would increasing U.S. interest rates to narrow interest-rate differentials to attract capital.      

The more competitive dollar has already begun to improve our trade balance, which, in turn, has been crucial in keeping our economy from slipping into recession.  Exports are growing nicely, but the improvement has been only modest because of the higher prices paid for imported oil.  As I've said before, give us a strong dollar, but not just yet. We still need a competitive dollar to keep us out of recession.