To rather lackluster fanfare in the “public consciousness” yesterday, the Federal Reserve announced that it was holding interest rates flat, and hinted that it may need to raise interest rates in the near future as it is becoming increasingly concerned about inflation. All of this has me wondering - are we heading for global recession?

Inflation is an insidious destoyer of wealth, and the Federal Reserve is often handicapped in combating inflation without also causing impact in other aspects of the US Economy (like recession). As it stands right now, energy prices, food prices, and general prices, all seem to be under considerable pressure to rise. Moreover, wages paid to workers have been flat. That situation is dangerous given the other problems (such as a credit crush) the economy is facing. The Fed is probably facing the biggest crisis since its formation.

Today, the Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyzes the major central banks. A report by the bank’s research team warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as “all the chickens come home to roost” from the excesses of the global boom, with contagion spreading across Europe and emerging markets.

World central banks may be placed in a difficult situation given these factors. The normal way central banks respond to inflationary pressures is to reduce the money supply. Economists have long theorized that long-run inflation is fundamentally caused by an imbalance between demand and money supply. Short-run inflation is thought to be caused by wage-stability, interest rates, and price expectations. As you can see - the only tool the Fed has is monetary policy. Thus, to combat both long and short-term inflation, it can only use interest rates. (The Treasury could adjust money supply as well, however, changes in money supply are more difficult and often lead to more dramatic results.)

So, the Fed is fundamentally facing this question - do I raise interest rates, and thus head off inflation, but potentially stall a precariously placed economy? Or, do I leave interest rates alone, alienate investors in US markets by having them abandon dollar denominated assets, and have inflation increase, but potentially also keep growth positive.

It is not a simple choice. If you don’t raise interest rates, you almost certainly spark a sell-off of US assets, which makes the economy weaker, and causes a credit crunch. If you do raise interest rates, you make consumer activity more difficult, you make borrowing more difficult at a time when most mature economies in the world are trying to deal with underlying debt and finance crunches, and you might achieve lower inflation, but also lower growth (or potential recession).

Barclays Capital said in its closely-watched Global Outlook that US headline inflation would hit 5.5% by August and the Fed will have to raise interest rates six times by the end of next year to prevent a wage-spiral. If it hesitates, the bond markets will take matters into their own hands. I don’t know if it will hit 5.5%, or if six rate hikes are what will be required. The Fed can move quickly - and raise rates quickly if they think such action is necessary. However, I agree generally with both RBS and Barclays that the situation is precarious.

High oil prices are a drain on America, Europe, Japan, and other oil-importing countries. America’s oil-import bill over the past year alone is estimated to have risen by around $125bn. If there were any assurance that prices would remain permanently at $100 or more a barrel - alternative sources for fuel would attract investment. But we are now in the worst of all worlds - prices so high that they damage the global economy, but uncertainty about America’s energy plan and the long-term outlook on prices so severe, that the investments needed to bring prices down in the long-run are not being made. High oil prices are going to drive inflation. Low consumption will drive wages downward.

All in all - it’s a disaster waiting to happen.