WSJ (3-24-2011) Crises Scramble Fed's Inflation Calculus by David Wessel
or watch this interview with David Wessel (3 min)
David Wessels points out that if fears of oil price increases drive up prices (make AS shift left), the Fed will not be able to keep stimulating demand (make AD shift right) without further driving up prices.
Currently the Fed is keeping interest rates low and buying assets, and thereby pumping money into the economy. In the graph below, this policy results in a rightward shift in the aggregate demand curve from AD1 to AD2. This should move the U.S. economy from point 1 (now) to point 2 (by about 2012). If all goes as planned, the U.S. would enjoy higher output (and hence lower unemployment) with only a slight increase in prices.
Unfortunately for the Fed, oil prices increases and inflationary fears may shift the aggregate supply curve left from AS1 to AS2. If the Fed sticks with its current policies, this decline in the AS curve would send the economy to point 3, with rising prices (i.e. inflation). To fight inflation, the Fed would be forced to stop stimulating demand; AD would stay at AD1 instead of shifting right to AD2. The Fed would have to raise interest rates and/or stop buying assets.
So instead of moving from point 1 to point 2, with more output (and less unemployment) and mild price increases, the U.S. could end up at point 4, with less output (and more unemployment) and price increases. The Fed's hands would be tied. Due to higher inflation, it would not be able to maintain an expansionary monetary policy intended to increase output.