Goldilocks Doesn't Live Here Anymore

Higher oil prices even could generate inflation without much economic growth, Paul McCulley, Pimco's chief Fed watcher, said last week on Bloomberg television after the latest rate hike.

"An energy shock has a stagflationary smell to it and that's reality," he said. Stagflation, the scourge of the 1970s, occurs when prices rise not due to increasing economic growth but because of other factors, like the OPEC oil embargo.

There's been some debate over what the Fed was trying to signal last week with its statement that the economy had "regained some traction." Some read that as a weaker assessment that the Fed's August description of an economy "poised to resume a stronger pace." McCulley didn't see it that way: The Fed showed no signs of halting its "measured" campaign to raise rates, he said, calling the most recent statement "as hawkish as you can get."

Elephant in the Room

State Street Research economist John Balder has an explanation for why the Fed might be leaning toward letting some inflation percolate. He argues that policymakers are backed into a corner because consumers have racked up record debts. According to the most recent release from the Fed, households owe $9.7 trillion, while businesses owe $7.6 trillion and the federal government is in the hole for $4.3 trillion.

If the Fed raises rates too much to guard against inflation, then the economy will slow down, reducing the ability of consumers and businesses to pay back the loans and, in many cases, increasing the interest rates on the loans, Balder said. In Japan over the last 20 years and in the U.S. during the Depression, excessive debt and a slowing economy led to massive deflation, or falling prices.