AS THE ECONOMY slips deeper into recession, the Federal Reserve is seemingly faced with a no-win dilemma. Because of the Persian Gulf crisis and the persistent budget and trade deficits, we face not only recession but also inflationary pressures at the same time, as in the late 1970s.
In the past, the Fed has been criticized -- justifiably, in my view -- for assigning top priority to controlling inflation, even at the cost of deepening a recession. At several points in the recent past, most notably the recessions of 1974-75 and 1981-82, the Fed has been quite willing to strangle the economy in order to damp down inflationary pressures.
For the moment, the Fed is trying valiantly to stave off recession and save the fragile banking system from collapse. For the past several weeks, it has been attempting, uncharacteristically, to loosen money policy in order to drive down interest rates and stimulate the economy.
However, there are voices within the Fed and on Wall Street which still consider inflation the greater menace. The measured rate of inflation is likely to continue rising, thanks in part to higher oil prices, higher health-care costs and our continued dependence on foreign borrowing. And if war comes, inflationary pressures will only intensify.
But if the Fed reverts to its usual habits of worrying more about inflation than recession, it would be particularly dismal for the economy because of the nature of this recession.
First, the real economy is extremely soft. The sources of inflation result not from a generally overheated economy, but from sectoral inefficiencies (for example, out-of-control health-care costs) and external shocks (the effects of the Persian Gulf crisis on the price of energy).
Second, the entire real estate sector is in a deflationary cycle. Falling property values lead to loan defaults, which in turn undermine the banking system. Any attempt by the Fed to tighten money would only make this worse.
In these circumstances, a little inflation might not be so bad. For one thing, it might send investors back into real estate, which would then help rescue the banks. For another, it would leave debtors (including the U.S. Treasury) repaying their debts in slightly cheaper dollars.
However, the underlying problem is not that policymakers are insufficiently tolerant of inflation. It is their refusal to look beyond a static "trade-off" between the twin evils of recession versus inflation.
There are other available strategies which attack sectoral inflation at its source rather than crudely squeezing it out by flattening the entire economy. For example, a serious energy-sufficiency policy would reduce our vulnerability to sudden oil-price shocks.
lTC A universal approach to health care would moderate medical inflation. Many economists have long recommended that we pursue an "incomes policy" -- a social compact tying wage increases to increases in real productivity, so that tight labor markets do not lead to inflationary wage pressures. The administration might even consider a strategy of wage and price restraint, particularly if the Persian Gulf crisis turns into a shooting war.
It may seem odd to think about these sectoral anti-inflation strategies at a time when the bigger threat to the economy is recession. But if the government had these measures at its disposal, it could stimulate an economic recovery with far less fear of setting off a new round of inflation. The time to fix the roof is before it rains.
A further source of inflation is the weak dollar. The weak dollar, in turn, reflects the declining competitiveness of American industry and our trade and budget deficits.
Here again, the failure to have coherent sectoral policies -- in this case more aggressive fair-trade policies -- leaves policymakers with an unpalatable choice of lesser evils. The Fed can lower interest rates, but that only makes the dollar a less attractive investment for foreigners, and drives its value even lower. And a cheap dollar, in turn, triggers imported inflation. But if we had a more consistent trade policy, and more nearly balanced trade accounts, we would have less need to import capital.
Beyond a certain point, the Fed has very limited running room. It is constrained by the effects of a decade of bad policy. That, however, is no excuse for compounding bad policy. The Fed should not become obsessed with the risk of renewed inflation when the more serious danger is deep recession.
Inflation has far more complicated causes than budget deficits or tight labor markets. If the government were more creative about addressing the complex sources of price inflation, it would be under less pressure to view the world as a series of dismal trade-offs.
And the real economy would be better served.
Robert Kuttner writes regularly on economic matters.