Jan. 11 (Bloomberg) -- There's inflation and there's deflation. Both are bad, especially in excess, though stagflation -- defined as no or slow economic growth combined with a rising inflation rate -- holds a special place in the darker recesses of the dismal science's pantheon, not the least because of the dilemma it poses for central banks.

``Cutting interest rates to prevent a recession could stoke inflation pressures further,'' says Joachim Fels, London-based co-chief global economist at Morgan Stanley. ``Conversely, raising rates or keeping them unchanged could push the economy over the brink.''

Central bankers aren't stupid. They understand the options facing them. Yet, like deer frozen in the headlights of an oncoming car, they seem unable or unwilling to wholeheartedly attack either the slow-growth problems facing the global economy or the inflation pressures. Instead, by adopting half measures, they act as if they are trying to wish the world's difficulties away and continue to let them fester. By so doing, they increase the probability of eventually being overwhelmed by stagflation.

``So far, the Fed is behaving like it will not have to deal with slow growth and higher inflation simultaneously,'' says Alan Ruskin, chief international strategist at RBS Greenwich Capital Markets in Greenwich, Connecticut. ``Either weak growth will solve the inflation problem, or growth will reaccelerate and there will be an inflation problem.''

Stagflation

First, the ``stag'' part of the argument. U.S. manufacturing sits near five-year lows, while hiring in December rose by 18,000, the least since August 2003. Meanwhile, European retail sales in November fell the most in at least a decade, and U.K. house prices declined 0.8 percent in the fourth quarter, the first drop since 2000.

As for the ``flation'' part of the equation, soaring food and energy prices have pushed the U.S. consumer inflation rate to 4.3 percent, the most since June 2006, while the comparable euro- area figure is 3.1 percent, the highest in more than six years.

In theory, slowing growth should reduce inflation, because it widens the so-called output gap, or difference between a country's actual and potential gross domestic product. Yet the causes of countries' inflation have become more global.

Globalization initially helped lower inflation. ```More recently, however, globalization has turned into an inflationary force, due to expansionary monetary policies in the emerging world, which fueled strong overall demand growth, and specifically demand for energy and food,'' Fels says. ``Rising energy and food prices have pushed total inflation higher also in the advanced economies.''

ECB Stays Put

Central bank responses to the stagflation threat have been a cross between generals fighting the last war and bureaucrats muddling through. The U.S., U.K. and Canada -- countries with relatively high interest rates -- have eased monetary policy, while the European Central Bank, Bank of Japan and Swiss National Bank -- institutions with relatively low rates -- have shelved plans for rate increases.

The Fed cut its key federal funds rate by 25 basis points to 4.25 percent on Dec. 11 when the market was looking for more. Even so, as of yesterday there was a 70 percent chance the Fed will cut rates to 3.75 percent on Jan. 30, while the odds are 70 percent of a reduction to 3.50 percent on March 18, according to futures prices. The odds of another cut to 3.25 percent in April are 63 percent.

Eventually, the Fed will have to give the market what it demands. Meanwhile, the ECB keeps sounding the alarm about inflation when the bigger risk is that euro-area growth will grind to a halt. The longer it delays cutting rates, the bigger the eventual rate cuts may have to be.

Ahead of Curve

Instead of doing a dance of denial, central banks should show they are ahead of the curve, cut rates, restore growth and then turn their guns on inflation.

Any discussion of stagflation conjures up memories of the 1970s, when the term became part of the public lexicon after the oil shocks of 1973 and 1979-1980 and the ensuing recessions of 1974-1975 and 1980.

Yet much has changed during the past 30 years. Countries are more energy-efficient, economies more flexible and unions weaker. In short, oil prices don't affect the global economy as much as they once did.

``As long as there are no severe supply restrictions, we don't expect further oil-price increases to pose a major threat to world growth and inflation,'' Deutsche Bank AG economists Peter Hooper, Thomas Mayer and Torsten Slok said in a November report.

Better hope these guys are right -- or that central banks bite the bullet soon -- because the 1970s were an absolutely dreadful decade for investors.

(Michael R. Sesit is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Michael R. Sesit in Paris at at msesit@bloomberg.net

Last Updated: January 10, 2008 19:05 EST