There’s something strange about the inflation problem the Federal Reserve is trying to solve right now.

Headline CPI inflation is running at 3.4%. That sounds uncomfortably high. But underneath that number, the picture looks very different. Core CPI, excluding food and energy, is 2.4%. Strip out food, shelter, and energy and inflation is just 2.0%.

Energy, meanwhile, is up 16.3% over the past year. Gasoline is up 27.4%. In August alone, gasoline accounted for more than one-third of the monthly increase in CPI. (BLS)

In other words, a significant part of the current inflation problem isn't broad-based overheating of the U.S. economy. It's an energy problem.

And much of that energy problem originates with a physical supply constraint created by geopolitical conflict and disruption to Middle Eastern energy flows.

That creates an uncomfortable question: What exactly is the Federal Reserve supposed to do about it?

The Fed can't produce another barrel of oil. It can't reopen a shipping lane or repair disrupted energy infrastructure. Its primary tool is the interest rate.

And in September, the Fed raised its target rate another quarter point to 3.75–4.0%, citing elevated inflation and resilient domestic spending. (Federal Reserve)

Higher interest rates can bring oil prices down. But consider how that mechanism actually works.

The Smiths decide they can't afford the trip to Hawaii this year.

The Joneses cancel their cross-country road trip.

A business postpones an expansion.

Someone doesn't buy a car.

A construction project doesn't get financed.

Eventually businesses hire fewer people. Some workers get fewer hours. Some lose their jobs.

All of those decisions reduce economic activity. And reduced economic activity means less gasoline, jet fuel, diesel, freight, electricity, and ultimately less demand for oil.

Enough demand destruction can bring the price of oil down even when supply remains constrained.

Economically, the mechanism works.

But it is an extraordinarily blunt solution to a very specific problem.

Who absorbs the pain?

There's another dimension that's easy to miss when looking only at aggregate inflation statistics.

The households most affected by expensive gasoline aren't necessarily the households most capable of absorbing it.

For someone with substantial wealth, an extra $50 at the gas station is irritating. For a household living paycheck to paycheck, that same increase competes directly with groceries, rent, childcare, or savings.

Then monetary tightening arrives.

Higher borrowing costs and weaker employment don't affect everyone equally either. Rate-sensitive households, small businesses, borrowers, and workers vulnerable to unemployment can experience much larger effects than households sitting on substantial financial assets.

That creates a potentially perverse sequence:

Oil supply falls.

Gasoline becomes expensive.

Lower- and middle-income households get squeezed.

Then the Fed raises rates to reduce demand.

The economy slows.

Hiring weakens.

Some of those same households lose hours, income, or jobs.

Eventually oil demand falls enough that gasoline becomes cheaper.

Put provocatively, the tradeoff can begin to resemble:

Would you rather have expensive gasoline and a job—or cheaper gasoline because enough people lost jobs that oil demand fell?

That's an oversimplification, of course. The Federal Reserve has a legitimate reason to worry about an energy shock spreading through the economy.

Oil raises transportation and production costs. Workers may demand higher wages to compensate for lost purchasing power. Businesses may pass those costs along. If everyone begins expecting persistent inflation, a temporary oil shock can become a broader wage-price cycle.

That is the scenario monetary policy is supposed to prevent.

But there's an important empirical question: Is that actually happening?

So far, underlying inflation looks considerably calmer than headline CPI. Core inflation is 2.4%, and inflation excluding food, shelter, and energy is 2.0%. Fed Governor Christopher Waller recently noted signs of disinflation even while acknowledging considerable uncertainty from military conflicts and other forces. (Federal Reserve)

That doesn't prove the Fed is making a policy error.

It does raise the bar for additional tightening.

If an external supply shock is becoming embedded in wages, expectations, and broad consumer prices, tightening monetary policy may be necessary despite the economic cost.

But if inflation remains largely concentrated in energy and closely related categories, the calculus looks very different.

In that case, the Fed is effectively responding to a shortage of oil by making the rest of the economy weak enough to consume less of it.

That may bring inflation down.

The more important question is what price we're willing to pay to make that happen—and who ends up paying it.