[jyl]

Much of the current US inflation is externally generated. High growth in China/India/etc so upwards pressure on energy and commodity prices. Very low interest rates in Japan adding to liquidity. War, the military and political kinds, in Middle East driving up oil prices.

Thus changes we make internally, such as raising interest rates and depressing economic growth, have less impact on US inflation. Because of these external factors, I think we probably need a larger US slowdown to bring inflation down to 1%+ range.

I also recently read a study that concluded the current US economy, compared w/ the past US economies, requires more pain (this might have been measured in job loss, I can't recall) to produce a given level of economic slowdown. It wasn't a very deep analysis but still interesting.

On the related topic of what the Fed will do - Bernanke is focused on expectations of future inflation, in addition to or perhaps in place of, current inflation. So while the headlines focus on each month's CPI data, he is presumably looking at survey and market-based measures of future inflation expectations, as well as his models of future inflation.

I think this increases the risk that the Fed will not raise rates enough, and thereby fail to control inflation. Compared to a Fed that was focused on current inflation and thus would raise rates until CPI is knocked back to 1%; that Fed would have a higher risk of raising rates too much. Of course, in the end the Fed's #1 job is to control inflation so if they cease raising rates too soon, they'll have to resume raising.

This all makes me worry about a 2007 scenario in which the US economy is in a substantial slowdown or recession, but the Fed is actively raising (not lowering) rates.

That would be a pretty bad situation. Memories of 1970s stagflation, and just look at the 1970s stock market.