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Two days ago, the Federal Reserve announced it would leave rates unchanged. The stock markets rallied on the news because traders interpreted the Fed's statement as implying a rate cut was more likely. Granted, there is a ton of "reading between the lines" when it comes to Fed statements (in fact, there are people who actually make a career of interpreting these statements). However, what traders failed to realize -- and what most economists did realize -- was the Federal Reserve is caught between the proverbial rock and a hard place. While the economy is obviously slowing, inflation has not.

Let's back up to late last summer when the Fed stopped raising rates. Paraphrasing most of their public statements goes something like this: As the economy slows, so will inflation. What the Fed was counting on was decreased supply and demand that naturally results from slower growth would lead to lower prices.

They have half of the situation right. GDP growth is much slower, coming in at 2%, 2.6%, and 2.2% for the 2nd - 4th quarter of 2006, respectively. Housing has the big reason as it decreased 11%, 19% and 19% in the same quarters. Right now manufacturing is hanging between expansion and contraction. Consumer spending is the one strong point of the economy, but it is slowing as well as evidence by the last few retail sales reports.

So we have slower growth. The problem is inflation is not slowing as predicted. Here is a year-over-year graph of the percent change in inflation. It comes from the blog The Mess That Greenspan made:

Inflation is running hotter than the Fed would like. There are several problems. First, gas prices are increasing:

And agricultural prices are increasing as well:

Both of these graphs indicate prices for staples -- goods we pretty much need -- are increasing. This is what makes the core price changes so important. When the Fed -- or any other economist -- is talking about core rates (rates less food and energy), one of the things they are looking to see is how price increases in food and energy are bleeding through into other prices. That's why the year-over-year changes in core inflation are so important from a policy perspective. The increases mean energy and food costs are bleeding through into other prices in a variety of ways. For example, increased energy prices means transportation costs are increasing, which means companies have to raise prices to pay for the increase. Increased food prices means eating out is more expensive, hence restaurant prices increase. You get the idea.

The Fed may have to make a very difficult choice in the coming year: choosing to lower rates -- despite inflationary pressures -- to keep the economy from moving into a recession, or to stimulate the economy out of a recession. If they do that when inflation is increasing, they run the risk of allowing inflation to get out of control. And no central banker wants that.

In other words, it really sucks being on the Fed right now.