Editor’s Note: The Fed and the ECB have taken up opposing positions in the current economic battle, says Mike Burnick. Bernanke & Co have chosen to protect economic growth from the threat of tumbling asset prices. In Brussels, the priority is controlling inflation. This is bad for the dollar, says Mike, which will drive commodity prices higher still. There is no pain-free solution, he adds.

Inflation or Deflation…Pick Your Poison

By Mike Burnick

“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. Bernanke and company were unable to reach a consensus last week about how to deal 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 just raised its benchmark rate to ward off inflation- now at an uncomfortably high 4% in the Eurozone.

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 yields 4.25% (the ECB benchmark rate as of yesterday’s meeting).

That’s why Treasury Secretary Paulson was busy with a four-day, whirlwind tour of Europe earlier this week. He’s desperately trying to talk ECB finance ministers into a less-hawkish stance.

After all, higher Euroland rates could send the dollar plunging further. That 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…

Source: Inflation or Deflation…Pick Your Poison