Nov. 13 (Bloomberg) -- When the Federal Reserve talks about the risks to the economy, be it slower growth or higher inflation, it's usually an either/or proposition.

What if it's both? What if the U.S. economy is facing the prospect of slower growth and higher inflation, a dual diagnosis requiring offsetting actions for each symptom?

Certainly that's where the risks lie, as Fed Chairman Ben Bernanke pointed out in congressional testimony last week.

``The Committee recognized that risks remained to both of its statutory objectives of maximum employment and price stability,'' Bernanke said, explaining policy makers' outlook at the conclusion of the Oct. 30-31 meeting.

Bernanke enumerated the ``downside risks'' to the Fed's already slow-growth forecast: a deterioration in financial market conditions; a further tightening of credit standards; a steep decline in home prices that depresses consumers' willingness to spend; and a deceleration in business investment in response to a dimming economic outlook.

As for inflation, it's the usual suspects that pose a risk, according to the Fed chief: the soaring price of oil and other commodities and the decline in the foreign exchange value of the dollar. These price changes may be symptoms, not causes; they may be relative price shifts (in the case of commodities), not inflation per se. The Fed doesn't elaborate on how it views the cause-effect relationship between policy and prices.

So how big an impediment is the weak dollar to the Fed's best laid plans for averting a recession? Economists are of two minds (only one mind per person) on the dollar's impact on inflation and monetary policy going forward.

Next Move?

``It's `check' for the economy now; it's facing `checkmate,''' says Paul Kasriel, director of economic research at the Northern Trust Corp. in Chicago. ``Checkmate is the dollar. Bernanke's problem is that if he cuts, the dollar will go down even more. He may not be able to provide as much support for the economy as his predecessor.''

That's not good because, if Kasriel's correct, the economy is showing signs of moving toward recession: two months of soft chain store sales; an increase of 0.1 percent in real consumer spending in September; a ``loss of altitude'' in the Institute for Supply Management's manufacturing index; and a sharp decline in consumer sentiment, with the University of Michigan's expectations index down 22 percent in the past year.

Flashing a Warning

What's more, the Kasriel Recession Warning Indicator (KRWI) is flashing yellow. Both components -- the spread between the federal funds rate and the 10-year Treasury note yield, and the inflation-adjusted monetary base (currency plus bank reserves) - -have turned negative, a precursor to every recession since 1970. (Kasriel uses the year-over-year change in the monetary base's quarterly average and the four-quarter moving average for the spread.)

The KRWI has been negative for three consecutive quarters. The Fed may be forced to choose in the not-too-distant future between the currency and the economy-at-large.

While the dollar's daily decline to new lows isn't good PR for a country or its economy, it may not have significant inflationary consequences, according to Stephen Cecchetti, professor of international economics at Brandeis University and a former research director at the New York Fed.

``Nothing leads me to suggest that there's an inflationary pass-through from dollar depreciation,'' Cecchetti says.

The rule of thumb is a 10 percent decline in the dollar translates to a 0.1 percentage point rise per year in the consumer price index for two years, he says. The dollar is down 9 percent so far this year versus a basket of major currencies.

The weak dollar ``is not adding much on the inflation front and it's adding more on the growth front,'' Cecchetti said.

Still Moored

Net exports (exports minus imports) added an average 1.1 percentage point to gross domestic product growth in the second and third quarters of this year. Goods exports added 1.7 percentage points, the biggest contribution in almost 30 years.

And as for the People's Bank of China dumping its U.S. Treasuries, it's ``counterproductive to start a fire sale,'' Cecchetti says.

The main danger is a collapse in the dollar. Policy makers don't like disorderly market moves, number one. And number two, the risk is inflation expectations come unmoored.

So far, there's been little evidence of that happening. The five-year expected inflation rate five years from today, a preferred Fed gauge, is 10 basis points higher than at the start of the year, at 2.47 percent. It's lower than it was on Aug. 17, when the Fed first addressed the deterioration in liquidity and credit conditions with a 50-basis-point discount rate cut. The Fed subsequently lowered its benchmark rate on Sept. 18 (by 50 basis points) and Oct. 31 (25 basis points) to stand at 4.5 percent.

`Credit Events'

Besides, credit events are deflationary by nature. Simply put, when lenders sustain large losses, they can't extend credit.

With the financial sector reeling from losses on subprime loans and the securities linked to them, the crisis isn't likely to be ``contained,'' the official party line until recently.

Foreign lending institutions have already been infected and growth is slowing in Japan and Europe, which may have implications for their currencies. That may make the choice easier when the Fed opts to throw the dollar overboard to steady the U.S. economy.

(Caroline Baum, author of ``Just What I Said,'' is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: November 13, 2007 00:07 EST