By Nin-Hai Tseng
March 9, 2011

Higher oil prices are igniting a fierce debate inside the Fed: Will continuing QE2 lead to higher inflation, or will it prevent it?

Up until recently, there was pretty overwhelming support by central bankers to keep U.S. interest rates low by buying up bonds in a second round of quantitative easing with the goal of boosting our slow-growing economy.

But the debate over the right policy prescription is about to get more complex (if it isn’t already), as the Federal Reserve now has to deal with higher oil prices that could add to inflationary pressures.

When Fed chairman Ben Bernanke launched the $600 billion QE2 in November, oil prices were trending up but still below $100 a barrel. That’s the psychological barrier where many economists believe it begins to dampen consumer spending, as it tends not only to raise prices at the pumps but also push costs up for transporting everything from food to clothing. Though prices for crude oil retrenched some this week, it passed $100 a barrel last month and has rallied almost 25% since unrest in Egypt erupted at the end of January.

Generally, higher oil prices can play out a few ways:

In a weak economy, higher prices could hurt consumption and even encourage a recession, which is more or less what happened in December 2007 when the U.S. slipped into a period of negative growth as oil prices surpassed $140 a barrel at a time when the nation’s financial system nearly collapsed.

But in a strong economy, higher oil prices could spur inflation. More importantly, companies can cushion against higher prices for raw materials by being able to raise their own prices.

Higher prices could also lead to stagflation, where inflation rises with high unemployment and a weak economy.

So what’s the Fed to do? Certainly the policy response seems just as hard as predicting which scenario could eventually play out.

The Fed has continued with its bond-purchasing program, saying inflation hasn’t been a threat. As recently as last week, Bernanke testified before the Senate Banking Committee in Washington that the surge in oil and other commodity prices probably won’t lead to a permanent increase in overall inflation.

But Bernanke’s answer to a weak economy hasn’t exactly flown without criticism. World leaders have blamed Bernanke for strengthening their currencies as they tried to keep their own economics chugging along. What’s more, the bond-buying program has been criticized for sending prices for commodities from cotton to wheat surging, flooding a potentially unsustainable round of capital into economies throughout the world.

But Dallas Fed President Richard Fisher now says he may vote to stop it before the deadline if the policy threatens the economy. Fisher has long questioned the merits of the policy, and it appears that rising oil prices have only made him more skeptical.

Fisher, who this year became a voting member of the Federal Open Market Committee that decides monetary policy, isn’t alone. Kansas City Fed President Tom Hoenig has repeatedly voiced his dissent against the massive bond purchases, saying it would cause an increase in long-term inflation expectations and destabilize the economy.

Of course, those two positions are enough to reverse the rotating 10-member committee’s efforts to flush the economy with capital. Oil prices are the new wild card central policymakers must deal with. And not every agrees how to respond.

Unlike Fisher, Atlanta Fed President Dennis Lockhart has said the Fed should carry out another round of asset purchases to keep the economy growing if high oil prices threatened to tip it into recession.

And it’s not as if the U.S. is the only ones grappling with this. Just last week, the European Central Bank warned it might raise interest rates after bank President Jean Claude Trichet to calm inflation. This comes as somewhat of a shocker, given that debt-ridden Portugal, Ireland, Greece and Spain remain dangerously close to defaulting.

Surely the oil play is bound to liven debate among central bankers with almost as much fervor as it has with commodities traders.

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