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Despite interest rate reductions, inflation is still an economic threat

The public grew frustrated late last year when central bankers kept banging on about the threat of inflation, even as economic conditions became noticeably weaker. Sure, oil and some other commodities were expensive, and the cost of goods from China was rising, but wages and consumer prices were still well behaved, central banks said. Home prices, moreover, were either increasing at slower rates or falling, heralding a slowdown.

Yet while the rest of us detected little evidence of inflation, Ben Bernanke, chairman of the U.S. Federal Reserve, Jean-Claude Trichet, president of the European Central Bank, and their peers could see it as plain as day. The picture suddenly became fuzzier last month to Bernanke when global stock markets plummeted, along with interest rates on ultra-safe government bonds. With so many investors apparently banking on a recession, raising the risk of its occurrence, the Fed reduced its discount rate twice within about a week, the only time that has happened since 1914.

The moves were understandable. When economic growth begins to peter out, central bankers are often forced into a Faustian bargain - making credit easier to stave off a more significant downturn but in the process raising the risk of inflation down the road.

Critics contend that some authorities, especially in the United States, are prone to give the Devil more than his due. Bernanke and Alan Greenspan, his predecessor, have been widely blamed for reducing interest rates more than was necessary to stabilize the economy, helping to create bubbles in Internet stocks and home prices.

One sign that inflation may not be as quiescent as many think arrived earlier this week when U.S. consumer prices came in stronger than forecast in January, sending the 12-month increase above 4 percent.

"We are concerned that the Federal Reserve is much better at cutting rates than raising them and is too anxious to preempt a slowdown which would hit inflation expectations on the head," said Max King, a strategist at Investec Asset Management.

Declaring that "inflation is the No. 1 long-term risk for financial markets," King went easier on the Fed's counterparts. "The U.K. and Europe have less trigger-happy central banks," he said. But their fingers are getting itchy, too. The Bank of England cut its benchmark rate at its meeting earlier this month, and Trichet has signaled that the European Central Bank will be easing soon. Some economists foresee a relaxation of credit in Japan later this year, too, despite decent economic growth - by Japanese standards - and interest rates already at 0.5 percent.

Even if European and Japanese central bankers are more rigorous in fighting inflation, other authorities there are not, King said. "Globalization is a significantly disinflationary process, but governments are squandering much of the benefit on a bloated state sector, regulation and barriers to competition," he said. "Eventually, the globalization process will run out of steam, but the momentum of government policy will continue. Inflation will then be back as a serious problem."

But not just yet. "Inflation will diminish this year, perhaps by more than is forecast," King said. He added ominously: "Bond yields show that investors have no long-term concerns. I am not so sure."

King is not alone in fearing a false dawn. "We would be extraordinarily lucky to find that we had got everything spot on and that the world sailed on with stable growth and low inflation," said Alan Brown of Schroder Investment Management.

For him, the two most likely outcomes are "a long, Japanese-style economic winter" or a V-shaped snapback. The second would be more desirable - and is more likely, in Brown's view - but the benefits might be fleeting if inflation sparked by a swift rebound resulted in a fresh round of rate increases, leading to a protracted recession.

If King and Brown are right, what should investors do? Stocks are fairly inexpensive and stand to get a lift in coming months from easier credit policies. High-yield debt may gain, too, as risk appetite returns and odds of default diminish.

Assets that almost certainly would lose value are long-term government bonds. With yields ranging between 1.5 percent or so in Japan and 4.6 percent in Britain, 10-year bonds promise almost no return above recent levels of inflation.

"They are telling us that inflation is not a problem," King said. His advice: "Sell."