INFLATION´S SIREN SONG / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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MARCH 16, 2010, 3:57 P.M. ET.

Inflation's Siren Song .

By DAVID REILLY

Inflation is a tempting seductress, especially in an economy overburdened by debt and unemployment.

Why not, the thinking goes, keep the stimulus taps open longer than necessary to ensure a vigorous recovery by allowing inflation to overshoot targets for a year or two? Think of it as another dose of adrenaline helping unemployment fall faster and helping to erode budget deficits.

The problem: Once unleashed, inflation can't be easily contained, and sometimes the measures needed to do so can choke off growth.

So far, the Federal Reserve believes substantial slack in the economy makes inflation a distant prospect. Even if prices do rise, it has strong faith it can control them.

But there is a growing drumbeat of support for higher inflation. Olivier Blanchard, IMF chief economist, recently suggested central banks consider raising inflation targets so they have more room to cut interest rates when crises hit. Some others argue employers and politicians are unwilling to address structural problems in the economy, leaving inflation as a more practical alternative.

"Inflation can achieve what no congress can, fast reductions in fiscal deficits," Christian Broda, head of international research at Barclays Capital, wrote in a research note on Monday.

Mr. Broda estimated that letting inflation run at 5% for two years, compared with the Fed's 1.5% to 2% target for core inflation, would reduce the unemployment rate by three percentage points.

Of course, that is beguiling with consumers and the country as a whole struggling. And given tame inflation in the face of huge stimulus in recent years, the idea of runaway prices seems a distant threat, as the Fed said Tuesday.

But the risk that the central bank gets softer on inflation lies in its dual mandate to achieve both price stability and maximum employment. A desire to attack unemployment could lead to calls for letting inflation run up quietly, even if the target rate remains unchanged. After all, if the economy really is recovering, zero interest rates could quickly become distortive.

Remember also that Fed Chairman Ben Bernanke's life study has been the Great Depression and how to avoid a repeat. Interestingly, that is at odds with the European Central Bank, whose view is heavily influenced by the hyperinflation of Germany's Weimar Republic.

Congress, which has attacked the Fed's independence, could also be an issue. It may push for inflation as an alternative to spending cuts or tax increases.

While attractive in the short-term, inflation would quickly be reflected in the cost of debt, hammering the value of fixed-income securities and pushing up the cost of borrowing. It could also hit the dollar and push commodity prices even higher. The experience of the 1970s shows how painful it can be to rein in inflation once unleashed.

So investors should be alert for any signs that the Fed is taking price stability for granted, or is willing to let inflation run above target. Heavy borrowers need to work through their problems to create a sustainable rebound.

Inflation would be a false fix.

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