The European Central Bank buildingJOHN MACDOUGALL
With their hands already full fighting deflation, European and U.S. central bankers also must combat investor fears of inflation that could push borrowing costs higher and delay recovery.
Global policy makers have aggressively eased monetary and fiscal policy to counter a deep economic downturn that has seen commodity and asset prices plummet. But these actions, led by the United States, have alarmed some who fear they will stoke inflation.
Traditional inflation harbingers like a steeper government debt yield curve and rising gold prices have flashed warning signals, while a weaker U.S. dollar and near doubling in oil prices since January have also got people worried.
"The timing of when you need to start contracting (monetary policy) is critical and most likely, because of the lags in policy ... they are going to be too late because of the politics of tightening," said Robert Eisenbeis, a former head of research at the Federal Reserve Bank of Atlanta.
"They are going to have to do it in the face of some fairly significant unemployment," said Mr. Eisenbeis, who is now chief monetary economist at Cumberland Advisors. The U.S. jobless rate rose to 8.9 per cent in April and some fear it will pierce 10 per cent as the recession squeezes employers.
To keep the long-term interest rates set by financial markets down, Federal Reserve and European Central Bank officials must persuade investors that they have an exit strategy from policies that have chopped interest rates and flooded financial markets with dollars and euros.
At the same time, they must avoid any signal that implies they will hit the monetary brakes too soon, or they could undermine the recovery by leading bond investors to anticipate higher interest rates, which could send yields rising.
Minutes of the Fed's last policy session on April 28-29 showed several officials had heard from business contacts worried about inflation. But they also showed that most policy-makers expect inflation to remain subdued over the next few years.
Many of the Fed officials felt the danger had diminished of a protracted period of deflation, which is a broad-based decline in prices of the type that inflicted a decade of stagnation on Japan in the 1990s. But some still saw risks slack in the economy could keep inflation perilously low.
"They are contending with the fact that some people in the market might be worried about inflation for all the wrong reasons," said economist Michael Feroli at JPMorgan Chase.
If concerns about inflation get priced into market interest rates and force them up, while inflation in fact stays low, interest rates would rise on an inflation-adjusted basis, which could stall any recovery.
Since the Fed has cut the benchmark overnight rates almost to zero, it must rely on massive injections of money into credit markets and direct purchases of U.S. Treasury bonds, or so-called quantitative easing, to offset any such tightening.
This delicate task has to be accomplished against a background of forces that can make everything much harder, like the recent slide in the dollar and spike in bond yields on fears over the massive U.S. budget deficit.
"As the world thinks the United States is recovering, or at least no longer getting worse at an accelerating rate, the dollar weakens. This exacerbates the inflation risk," said Ellis Tallman, an economics professor at Oberlin College in Ohio.
"If we get another financial market scare, a confidence shaker, and oil prices fall again, then the reversion to a stronger dollar in a flight-to-quality will exacerbate the deflation scare," he said.
Federal Reserve Board chairman Ben Bernanke spoke to this issue on May 11, when he said that the U.S. dollar would be strong because the Fed was committed to price stability, and was thinking carefully how it will eventually tighten policy.
"We are currently of course being very aggressive because we are trying to avoid another form of price instability, which is deflation, and weakening prices and economic growth."
"But we are also committed to removing accommodation in a timely way to ensure that as we come out of this episode and we move back to sustainable recovery, that we will have price stability, low and stable inflation going forward," he said.
ECB vice-president Lucas Papademos had a similar message on May 14, noting the ECB's exit strategy would depend firstly on the outlook for price stability, and the return to calmer markets.
"Once financial conditions and the macroeconomic environment improve, the nonstandard monetary policy measures taken should be quickly unwound," he said.
Economists do not see inflation closing in on the ECB's comfort zone of below but close to 2 per cent any time soon. The ECB's recent survey of professional forecasters showed inflation at 1.3 per cent in 2010.
"This is a central bank which has one single mandate in terms of price stability. Still in my view ... deflation risks are higher than inflation risks," said UniCredit economist Aurelio Maccario in Milan.