Back in the 1980's, when I was in graduate school, I remember my economics professor comparing the handling of the American economy with navigating a ship through a narrow channel with dangerous rocks on either side.

On the starboard side, the rocks represented inflation -- runaway prices that can ultimately destroy an economy. On the port side, the rocks represented anemic economic growth -- slow consumer spending, high unemployment, and low corporate earnings.

Today, the Federal Reserve Board of Governors, with Chairman Ben Bernanke at the helm, must be especially adept at handling the sails and rudder of this ship to avoid runaway inflation on one side, and economic recession on the other. It's pretty evident that it's not going to be easy.

On August 8th, the Fed decided to leave short term rates unchanged, after 17 consecutive increases, the longest consecutive string of rate hikes in Fed history. Here's the background.

Back in 2001, when the economy was beginning to slow down, the Fed began dropping the Federal Funds Rate, which is the rate that banks charge each other for overnight funds. After the 9/11 attacks, the Fed lowered the rate much more aggressively, ultimately dropping it to one percent.

In June of 2004, the Fed began a series of .25 point hikes that brought the Funds rate to the present 5.25 percent. Then-Chairman Alan Greenspan and present-Chairman Bernanke made it clear: the economy was showing signs of overheating and credit must be tightened to stave off the inflationary beast.

Normally, such a strategy should navigate the ship through the channel without any damage. But there are some anomalies in this channel that will make the job unusually difficult. Consider the following questions.

Over the last couple of years the "core" consumer price index (CPI), which excludes volatile food and energy prices, has been hovering around 2.50 percent. But the overall CPI during the same period, has been closer to four percent -- a much more uncomfortable number. Although economists like to look at the core rate as the "real" gauge, inflation is inflation to the American consumer. Just because the inflation is coming from "non-core" places (oil prices, the Katrina aftermath, housing prices, Mid-East conflicts, etc.), prices are higher regardless. Can the Fed control these kinds of things by adjusting short term rates? I doubt it.

The U.S. trade deficit has resulted in a far larger portion of U.S. Treasury bonds being held by outside investors. U.S. Treasuries affect mortgage rates. If the trade scenario changes and foreign investors lose their appetite for U.S. Treasury Bonds, wouldn't mortgage rates shoot through the roof, exacerbating the sharp slow down in home sales, and ultimately house prices? Such a scenario could create a recession with high interest rates. Does the early 1980's term stagflation ring a bell?

Well, this is merely conjecture. I would hope that the Fed has learned from past experience how to avoid a scenario of stagflation (rising prices and stagnant growth). My prediction is that the economy will indeed slow down and the Fed will begin to ease credit in 2007. Stay tuned.

Published: August 24, 2006

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, the president of PMC Mortgage Corporation in Alexandria, VA, is a mortgage columnist whose work has appeared in numerous consumer, real estate, and mortgage publications. Mr. Savage welcomes your questions for possible use in this column, however because of the volume of mail received, Mr. Savage cannot answer questions individually.