by Calculated Risk on 6/27/2008 10:54:00 AM

Tim Duy has another great post on the Fed being caught between inflation and recession: This Is Not Good. Here is his conclusion:

This is a no win situation...which way will the Fed turn? The Fed will hold the current policy in place until policymakers becomes sufficiently distressed by the impact of energy price inflation ... Note that market participants are increasingly aware that the Fed’s default policy for the time being is higher inflation, as evidenced by the rise in 10 year TIPS breakeven levels to 254bp today.

In theory, the best outcome is to find is a sweet spot that allows global growth outside of the US to decelerate while avoiding a free fall in the Dollar. In the absence of such equilibrium, the US economy can hobble along only as long as the following three conditions hold:

1. The Federal Reserve can maintain easy monetary policy.

2. The US government can sustain repeated fiscal stimulus measures.

3. China and the rest of the dollar bloc continue to be willing to accumulate US assets, primarily the Treasury debt needed for fiscal stimulus.

When these conditions no longer hold – such as the Fed needs to tighten to counter energy inflation, or the demand for US debt drops sharply – then I suspect the US economic environment will shift decisively toward higher inflation or significant recession.