Inflation or Deflation... Pick Your Poison

The U.S. economy, and most other developed nations continue to be squeezed between two opposing economic threats.

Commodity-price inflation and asset-price deflation are creating havoc with financial markets, while global consumers, businesses, and central bankers are caught in the cross-fire.

The U.S. Federal Reserve appears to be caught like a deer in the headlights, unable to reach consensus last week about the correct monetary policy prescription for dealing with the twin flations. The FOMC decided to hold-the-line, keeping the fed-funds rate steady at 2%.

By contrast the European Central Bank (ECB), confronted with the same economic data as the Fed, has reached the opposite conclusion. The ECB is threatening to raise interest rates at its upcoming policy meeting.

Data out today shows Eurozone inflation ticking higher to 4% - the highest ever. It seems this pretty much seals the deal for an ECB rate hike.

Of course this makes life difficult for the U.S. dollar. There is the slight matter of “yield differential”, which my friend and colleague Jack Crooks has discussed at length.

The dollar “yields” just 2% (the Fed funds rate) while the euro already yields 4% (the ECB benchmark rate) and is likely to go up at least another quarter-percent this week.

That’s why Treasury Secretary Paulson is in the middle of a four-day, whirlwind tour of Europe today, trying desperately to talk ECB finance ministers into a less-hawkish stance on inflation.

After all, higher Euroland rates could send the dollar plunging further, which in turn will lead to even higher commodity-price inflation. A vicious cycle if ever there was one.

The dilemma for central bankers around the world is trying to figure out which is the greatest threat to economic stability at present: 

A. The threat to growth from deflation in real estate and equity market values amid the housing recession and credit crunch.

OR

B. The threat to purchasing power that results from accelerating inflation rates around the world.

The Fed has focused more on the de-flation threat, while the ECB is more concerned with in-flation at the moment - and financial markets are caught in the cross-fire! Stay tuned...