03/03/2008 11:13 am ET | Updated May 25, 2011

The Fed is Not Between a Rock and a Hard Place

A friend wrote in despair that the Federal Reserve was between a rock and a hard place. A big time Wall Street friend says he may sell all his equities because of stagflation and all that debt out there.

If the Fed saves the nation from recession and credit crunch by reducing rates sharply and providing more credit, it will stoke inflation. If it worries too much about inflation, it may let the U.S. slide into a deep recession.

The good news is that Ben Bernanke, chairman of the Fed, is a lot smarter than his critics. I don't get to say that very often about Bush appointees. He made his academic hay at Princeton arguing that we should formally target inflation, meaning almost only worry about keeping it low, nothing else. Employment, growth and capital investment will inevitably follow. But my sense is deep down he knows better than that.

Last week, he testified that recession is his priority, not inflation, despite all the attacks on his policy-making by Wall Street's inevitable inflation hawks -- and of course the editorial pages of the Wall Street Journal (and a couple of mild thrusts from the New York Times and Financial Times).

The fact is that the current round of inflation, though nothing to scoff at, looks like it has been driven by speculators, not supply and demand. I don't mean that speculators are evil and destructive. They are usually aggressive investors looking for the best place to park their money. Now they like commodities -- oil, grains, etc.

But read the papers today and you will begin to see that more and more people are coming to realize this. Demand for oil is not very strong, in fact. One knowledgeable person wrote a letter to the Financial Times today thinking it will go down to $70 a barrel by year end.

And there may be other places to park money. There are a lot of anomalies in accounting rules and benchmark practices on Wall Street that are creating distortions. Ratings for municipal securities is one of them. And it is no longer a secret. A good buy, perhaps.

Conventional wisdom is by definition formed in a rear-view mirrors. But this is not the 1970s. When Nixon took office in 1969, inflation was already 6 percent, not the current 2.2 or so. Unions were very powerful. And OPEC was coming.

We don't have to stop inflation right now. A sharp slowing in the economy, which is very likely, will stop it on its own. Far worse would be a credit crunch of enormous proportion.

Bernanke's getting a lot of inevitable Monday morning quarterbacking. But he seems to have some guts. He was Bush's only competent appointment. As an aside, perhaps Gates at Defense also has a chance, I should add, to avoid the scorn of history. That jury is still out.