Resident Fellow  Desmond Lachman

One has to pity Ben Bernanke as the Federal Reserve faces its worst policy dilemma in many years. Should the Federal Reserve hang tough on interest rates to fend off the past demons of higher inflation at the risk of a deep recession? Or should it cut interest rates aggressively, as suggested by Martin Feldstein and Larry Summers, in order to prevent the economy from sinking into a protracted economic slump at the risk of stoking already high inflation?

By law, the Federal Reserve is charged with the dual mandate of seeking price stability and promoting sustainable economic growth and employment. The Federal Reserve presently interprets price stability as inflation of all items other than food and energy at between 1 and 2 percent. At the same time, the Federal Reserve considers that the US economy has the potential of growing at 2½ percent a year without generating inflationary pressures.

With headline inflation now having risen to 4¼ percent, or to its highest level in years, the Fed can hardly turn a blind eye to the present inflationary risks. To be sure, it can argue that skyrocketing international oil and food prices are mainly to blame for headline inflation's recent acceleration. It might also argue that, at 2¼ percent, core inflation, which excludes energy and food prices, is still relatively well behaved. However, the Fed certainly knows that if headline inflation were to remain high for very long, inflationary expectations would be stoked. And were that to occur it would be extremely difficult for the Fed to deliver on its price stability commitment.

Complicating the Fed's decision on interest rates is the fact that the US economy is now being simultaneously buffeted by three major shocks. Home prices are already falling at the national level for the first time since the Great Depression, the financial markets are experiencing their worst credit crunch since the late 1980s, and international oil prices are presently at record levels of over US$90 a barrel. These shocks must certainly heighten the likelihood of a recession in 2008.

The risk of a significant recession is made all the more real by the prospect that home prices will continue to fall in 2008 at an accelerating pace. Already heavily weighing on the housing market is the record inventory of 5 million unsold homes, which are around 2 million more homes on the market than is normal. That inventory could very well be boosted in 2008 by declining demand as adjustable-rate mortgages reset at an increased rate, as mortgage lending standards are appreciably tightened, and as speculative positions are unwound. Pricing in that outlook, the futures market in the Shiller-Case housing price index is suggesting that US home prices are likely to fall by between 5-10 percent a year over the next two years.

With the financial system already in turmoil, the US economy could find itself in a downward spiral were it to slip into recession. By further weakening the housing market and by undermining the financial system's collateral, a recession could aggravate today's already troubling credit crunch. And if the credit crunch were to worsen, the recession could deepen as banks became even more reluctant to lend, which would further weaken the housing market.

In a world of uncertainty, a prudent central banker needs to not only balance the risks of alternative scenarios but rather also needs to ask what might be the potential economic and social costs of alternative outcomes. Framing the choice in this way, serious questions must be asked as to whether Mr. Bernanke is being too timid in easing monetary policy to avert the dangers of a deep recession. This would seem to be particularly the case when one considers that the 100 point reduction in the Federal Reserve's federal funds rate to date has been offset by an almost equivalent widening in interest rate spreads in the market.

In present circumstances, it would seem that were the Federal Reserve to err on the side of too easy a monetary policy, core inflation could very well pick up to the 3-4 percent range. While certainly not a welcome development, a problem of that sort could be dealt with over time with a limited cost to the economy. By contrast, were the Fed to err on the side of too tight a monetary policy stance, it would be running the risk of a deep recession that would further undermine the soundness of the US financial system and that would unleash strong deflationary pressures.

As a serious scholar of the Great Depression and the bursting of the Japanese asset bubble in 1989, Mr. Bernanke has to know better than anyone else the costs of having too tight a monetary policy stance as a major housing price and credit market bubble are deflating. This has to give one comfort that the Fed will react aggressively should the present credit crunch get worse and should the economy show clear signs of faltering.

Desmond Lachman is a resident fellow at AEI.