Between a rock and a hard place

From the department of there-is-no-choice-but-to-amputate:

The U.S. economy not only faces the risk of a sharp slowdown from the housing market's contraction but also of an inflationary surge from sharply higher crude-oil prices and the weaker dollar, Federal Reserve Chairman Ben Bernanke said Thursday.

In prepared testimony to the Joint Economic Committee of Congress, Bernanke painted a picture of an economy in a perilous position, even though it has shown remarkable resilience so far this year, with third-quarter gross domestic product rising at a solid 3.9% annual pace.

Bernanke said that he and his colleagues on the policy-setting Federal Open Market Committee expect the economy to slow "noticeably" from the third-quarter growth rate and remain sluggish in the first half of 2008. But Bernanke also suggested that the hawkish members of the Fed might have a point about inflation.

There were downside risks to the subdued growth forecast, and upside risks to the benign inflation outlook, Bernanke said.

The FOMC also believes that overall and core inflation will be "in a range consistent with price stability" in 2008, Bernanke said.

He noted that prices for crude oil and other commodities have risen sharply in recent weeks and that the dollar has weakened in foreign-exchange markets.

"These factors were likely to increase overall inflation in the short run and, should inflation expectations become
unmoored, had the potential to boost inflation in the longer run as well," Bernanke said.

The run-up in crude prices since the FOMC meeting on Oct. 31 has "renewed upward pressure on inflation and may impose further restraint on economic activity," Bernanke said.

Bernanke bluntly said that headline inflation is going to rise in the short term.

The prospect of having to raise interest rates to control inflation is always an important yet unpleasant thing to do. That's why, these days, Central Banks have been made independent from political pressure and influence. Yet the current situation in America is more than just unpleasant, it is downright awful. With the Subprime meltdown tipping America into an almost certain recession, the Federal Reserve has been quick to slash rates to compensate. Yet Bernanke now admits that high inflation and the falling US Dollar are now beginning to worry him.

Essentially, Bernanke has only two choices when it comes to monetary policy - he can either lower interest rates (thus increasing the money supply) or he can raise interest rates (thus restricting the money supply).

If Bernanke (and the rest of the Federal Reserve) choose to lower interest rates they are essentially encouraging the development of inflation. Additionally, a lowering of interest rates will also make the dollar devalue even more. The growth of inflation - an ever upward spiral of prices - confuses the market and makes it harder for the market and for individuals to spend and invest properly. A growth in inflation will inevitably cause a recession - economic history is clear on that point. Moreover, with the US dollar devaluing, the price of goods and services procured from overseas will rise. Since America's economy is geared towards consumption (rather than production) a continual devaluing of the dollar will choke off the nation's ability to consume, thus encouraging a recession.

But what happens if Bernanke (and the rest of the Fed) choose to raise interest rates? This will halt the plunging value of the dollar and dampen inflation - but it will also cause an economic slowdown. Given that the economy is already in bad shape from the subprime meltdown and its knock-on effects, raising interest rates will sicken an already sick patient. The choice to raise rates will deepen the recession already underway.

What a choice. Bernanke can either choose to make the recession worse later (by lowering interest rates) or make the recession worse now (raising interest rates). This was the dilemma facing Paul Volcker in 1980. As chairman of the Federal Reserve he gritted his teeth and declared that inflation was the enemy to be fought, and raised interest rates to 13.5% in 1981. Inflation was killed, but the world endured a deep recession and America's unemployment topped 10%. But, if Volcker had not taken this step, the result would have been even worse over time.

The current economic conditions in the US warrant this sort of courageous action. If Bernanke and the Fed choose to fight inflation they will cause a world recession as serious as the early 1980s, if not more so. Yet if they choose to ignore inflation and lower interest rates, they will do even more damage.