Real threat is uncertainty, not stagflation:James Saft

New US$20 bills are printed at the Bureau of Engraving and Printing in Washington October 23, 2006. The problem isn't stagflation, scary as the specter of an ugly mix of poor or negative growth and high inflation is for investors. The problem is knowing which of the two to fear and fight.

LONDON (Reuters) - The problem isn't stagflation, scary as the specter of an ugly mix of poor or negative growth and high inflation is for investors. The problem is knowing which of the two to fear and fight.

A sustained period of both the fire of inflation and the ice of a credit crunch-induced slowdown is highly unlikely.

But with the U.S. and European economies giving out mixed signals, the big risk is that central bankers delay the needed remedy.

Markets have sold off in recent days as data seemed to show that inflation was again taking root, suggesting a possible bout of 1970s-style stagflation of economic growth woes combined with uncontrolled price rises.

Former Fed chief Alan Greenspan, who must haunt successor Ben Bernanke's dreams, helpfully took up the cry in an interview with American television over the weekend.

"We are beginning to get not stagflation, but the early symptoms of it," Greenspan said.

And indeed some of the data, prompted by soaring fuel and food prices, are troubling.

Headline U.S. consumer price inflation hit 4.3 percent in November from the year before, while producer price inflation at 3.2 percent on a year-on-year basis was its fastest since 1973, a time when comedians made a living telling jokes about the rising price of meat.

Euro zone inflation also rose in the month, to 3.1 percent year-on-year, the steepest rate in more than six years.

This comes against a background of the biggest housing downturn in more than a decade, a hobbled banking system and a potentially intractable credit crunch.

But while the combination of inflation and poor growth is daunting, currency strategist Stephen Jen of Morgan Stanley points out that the inflation data reflects the immediate past, rather than the future.

U.S. growth in the third quarter will be close to five percent and consumption is still strong.

"I continue to believe that if the U.S. falls into recession, inflation will decelerate," he wrote in a note to clients.

"The idea that the world suffers from stagflation is a notion I don't find compelling.

"Central banks are indeed in a difficult situation, because of the uncertainty of where the global economy is heading, rather than the risk that growth could fall while inflation accelerates."

RE-LIVING THE 70s, OR THE FIRST BUST OF THE 21ST CENTURY?

The 1970s, when last stagflation took hold in the major western economies, is an object lesson for today, according to Stephen Lewis, economist at Insinger de Beaufort in London.

Policy makers looked at the combination of an oil-induced price shock and lousy growth and decided to loosen policy and take their chances.

Inflation took hold and became embedded in the system via so-called "second round effects" when workers demanded and got big pay rises.

"Central banks saw the combination of rising inflation and weak growth and they gave priority to dealing with the growth," Lewis said.

"So they printed money. We had far less growth over the next 20 years than if they hadn't."

Workers, especially those who feel secure in their jobs, will push for inflationary pay hikes.

For example, Germany's IG BCE chemicals union last week said it wanted a pay increase of between 6.5 and 7 percent for 2008 for the 550,000 workers in the sector.

But how quickly would inflation subside if the U.S. slid into recession?

This partly depends upon how robust emerging market demand -- which has driven commodity and energy prices higher -- would remain.

But the really thorny problem is the nature of the credit crunch.

Banks are very unwilling to lend now, both because they need to rebuild their balance sheets and because they fear that other banks may have hidden or unknowable losses. The securitization market remains more or less closed and house prices look set for a sustained fall in both the U.S. and Britain.

All of these factors magnify and reinforce one another.

Crucially, all of them make cutting rates less effective, as rate cuts are either not passed on fully to borrowers or make no difference when loans are not made at all.

But even if not fully effective, interest rate cuts have an effect.

The cost of waiting, even out of fear of inflation, could be high.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: saft@reuters.com)