"I've worried about inflation every day since I learned about the phenomenon, 60 years ago."

--Warren Buffett

Well, it might be time for Warren, and you, to worry a little more. Inflation surged 5.6% year over year in July, the largest gain since Vanilla Ice was tearing up the charts in 1991. Don't worry -- it gets worse. If inflation had grown at the same rate it has in the past three months, we'd be enjoying 10.6% annual inflation.

That's terrible, yes, but you can look at the information in a couple of ways. July marked at least a short-term peak in energy prices. Oil has shed around 20% of its value in the past several weeks, with the price of gasoline tumbling too, of course. If that trend continues or at least plateaus, inflation numbers are bound to ease off a bit, thank goodness.

Yeah, that's the end of the good news
Unfortunately, it wasn’t just energy prices fueling the so-called consumer price index. Transportation gained 1.7% for the month. Apparel prices soared by 1.2%. Food prices jumped by 0.9%. Sure, energy takes the cake as the inflationary king, but the across-the-board increase makes it more likely that Bernanke & Co. won't be able to idle much longer and will eventually succumb to interest-rate increases.  

How devastating would that be? If you revolve around the word "credit," very. Leveraged financers such as Washington Mutual (NYSE:WM), Citigroup (NYSE:C), and Wachovia (NYSE:WB) would get a rude awakening, that's for sure. But (in economics, there's always a but) higher interest rates would bolster what some see as a key driver to oil's recent tumble -- the strengthening of the dollar.

By most accounts, that would mean bonus points for the economy. The value of the dollar is imperative in the fight against inflation, because so much of what we consume -- particularly oil -- is imported from foreign nations.

True, a higher dollar will hurt manufacturing and exports, but come on -- a lot of manufacturers are much more concerned with oil's pain than exports' gain. Nipping oil in the bud means energy-centric companies such as General Motors (NYSE:GM), Ford (NYSE:F), American Airlines (NYSE:AMR), and United Airlines (NASDAQ:UAUA) get a new shot at life. And how great would that be? These are some of the same names that have been laying off employees as if the companies' lives depend on it -- primarily because their lives do depend on it.

What now, Ben?
Hence the Federal Reserve's conundrum:

  • Higher interest rates: bad for banks and the overall economy.
  • Higher interest rates: good for inflation and the overall economy.

The choice falls between a domestic housing collapse and a global showdown over the value of the dollar -- ultimately meaning resources such as oil and food. This is nothing new. The question Ben Bernanke has to answer is whether to lessen the suffering of those reliant on credit (in reality, most of the economy) or ease the pain that's slowly eating a hole in everyone's wallet. Be glad you aren't the one who has to make that decision.

In my opinion, the choice should slowly move toward the latter. Yes, I know ... housing, subprime, bank runs, national debt ... higher interest rates have myriad problems that are by no means fun. Just ask the early 1980s. But at some point, the severity of inflation needs to be addressed: In the past year, real wages have declined by 3.1%. Keep that up long enough, and refinancing your house might become the least of your worries.

Zimbabwe, anyone?

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Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. He appreciates hearing your questions, comments, and complaints. The Fool has a disclosure policy.