Is Inflation the Right Battle?

BERKELEY – The Federal Reserve and other central banks are coming under pressure from two directions these days: from the left, they are pressured to do something to expand demand and hold down global unemployment; from the right, they are pressured to contract demand to rein in inflation.

This is a situation ripe for trouble, because one of these two diagnoses must be wrong. If the world’s central banks raise interest rates while the major problem is insufficient global demand, they might cause a depression. If they do not raise interest rates while the major problem is inflation, they might cause spikes in prices, rising inflationary expectations, and a stubborn wage-price spiral like that of the 1970’s that can be unwound only with a later, deeper depression.

I see the left as being correct – this time – in the global economy’s post-industrial North Atlantic core. Headline inflation numbers are the only indication that rising inflation is a problem, or even a reality. The American Employment Cost index and other indicators of developed-country nominal wage growth show no acceleration of change. And “core inflation” measures show no sign of accelerating inflation either.

The United States is experiencing a mortgage loss-driven financial meltdown that would, with an ordinary monetary policy, send it into a severe recession or a depression. In normal times, the Fed’s response – extremely monetary stimulus – would be highly inflationary. But these are not normal times. Indeed, the Fed’s monetary policy has not been sufficient to stave off a US recession, albeit one that remains so mild that many doubt whether it qualifies as the real animal.