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Inflation figures from the Labor Department show that prices over the last year have increased by 4.3 percent, while growing at a 6.8 percent annual rate over the last quarter. Most of the inflation is being driven by rising health care and food costs.

Federal officials also have concerns inflation could remain higher than desired for the next several years. If it continues to increase, it would put reverse pressure on the Fed to stop dropping interest rates.

The problem of course is if the Fed continues to fight a slowing the economy, the tool they use is lowering interest rate. When they lower interest rates, they add to the risk of generating inflation. So they're caught between a rock and a hard place.

From the time Ben Bernanke took over as Fed chief, he had vowed to battle inflationary pressures. The problems in the economy have forced him to take steps he would rather have not had to take in dropping the interest rates so quickly and deeply. Even with that, the Fed still sees its primary purpose to keep inflation in check.

At the same time, most are thinking they are going to continue to cut rates to keep the economy from sliding into a recession. It's a tough balancing act they face.

What others are saying

Fed's Economic Forecast Gets Gloomier

"Brian Bethune, economist for Global Insight, said Fed rate moves are far from over, noting, 'Problems in the financial and credit markets have deteriorated,' since last month, when the Fed pulled together its new outlook.

"The Fed now projects that the economy will expand by 1.3% to 2.0% in 2008, 'appreciably below' its potential. That's down sharply from its October projection of 1.8% to 2.5% growth. The economy grew by 2.2% in 2007."

Inflation riddle hard to figure out

"Competing evidence of higher inflation, the worst in at least two years, and possibly the first recession in seven years creates a quandary for everyone from Federal Reserve policymakers to ordinary investors.

"If the Fed keeps cutting interest rates, as expected, won't inflation pressures build? If the Fed fights inflation by being less aggressive in its rate cuts, won't the sluggish economy get worse?

"If investors hedging against inflation bid up commodity prices and shares of food and energy producers, won't the purchasing power of an overall portfolio be eroded by surrendering to inflation?"

Future Fed Cuts Uncertain With Rising Inflation, Slowing Economy
 
"Minutes from recent Fed meetings released Wednesday show that central bank officials are concerned about consumer confidence tightening credit and slowing both domestic and global financial markets. The Fed noted that both consumers and businesses were having a hard time getting credit and that lenders were still reeling from large mortgage-backed securities losses."
 
Fears of Stagflation Return As Price Increases Gain Pace

"Is the U.S. in a period of stagflation? Stagflation, a term coined in the United Kingdom in 1965, defined the years from 1970 to 1981 in the U.S. Inflation rose to almost 15%. The economy went through three recessions. Unemployment reached 9%. Fed Chairman Paul Volcker finally conquered inflation, but only by dramatically boosting interest rates, causing a severe recession in 1981-82.

"Today's circumstances are far from that. Inflation is lower. Unemployment has risen, but only to 4.9%.

"Yet there are similarities. As in the 1970s, surging commodity prices are leading the way. Crude oil rose to $100.74 a barrel yesterday, a new nominal high and close to its 1980 inflation-adjusted high. Wheat prices have hit a record. And, as in the 1970s, the rate at which the U.S. economy can grow without generating inflation has fallen, because of slower growth in both the labor force and in productivity, or output per hour of work."
 
Fed says rates could go either way

"The report indicates the Fed's willingness to adjust the rate down or up. The current rate, at 3 percent, 'appeared appropriate for a time,' the Fed said. But, 'when prospects for growth had improved, a reversal, possibly even a rapid reversal, might be appropriate.'" 
 
http://www.reuters.com/article/usDollarRpt/idUSN2132000220080221

Dollar drifts lower on US rate outlook; sterling up
 
"Markets have priced in the risk of another half percentage point rate cut at the Fed's March meeting, which would further erode the dollar's appeal to global investors. The perceived chances of a 50 basis point easing stood at 82 percent on Thursday, slightly down from previous sessions after data on Wednesday showed accelerating U.S. inflation. 

"In Britain, stronger-than-expected UK retail sales data gave sterling a boost as investors scaled back the likely extent of interest rate easing by the Bank of England this year.

"In contrast, the Fed said in its minutes on Wednesday that it was worried the U.S. economy would face further setbacks even after a series of aggressive rate cuts and sharply lowered its forecast for U.S. growth in 2008."

Fed Sees Rate Low `for a Time' Then Possible Reversal

Rising energy and commodity costs, along with food prices, are pushing up inflation. Crude oil rose to a record $101.32 a barrel this week.

"They've got a problem: they've got rising inflation and the likelihood of recession,'' Robert McTeer, former president of the Federal Reserve Bank of Dallas, said in a Bloomberg Television interview. "I don't think they can keep dropping their interest rate down.''