By Martin Feldstein

The European Central Bank and the Federal Reserve are facing similar problems but pursuing different policies. The ECB has been raising interest rates while the Fed has been cutting them. The overnight federal funds rate is now 2 per cent while the corresponding ECB rate is 4.25 per cent. Which central bank is doing the right thing? Or could they both be?

Inflation is a significant problem in both the eurozone and the US, with a headline consumer inflation rate over the past 12 months of 4 per cent in the eurozone and 5 per cent in the US. Both economies are also facing declining economic activity with falling employment and lower industrial ­production.

The sharp rise in the prices of energy and food during the past 12 months will undoubtedly spill over into higher prices for other products in both the US and Europe. The primary challenge for both central banks is to limit this inflationary shock to a one-time pass through, avoiding the rise in wages that would occur if employees attempted to offset the decline of their real incomes. It was that futile wage-price spiral that drove inflation rates in the 1970s to double-digit levels. Preventing a repetition of that requires convincing the public that today’s high inflation rate will soon decline.

The remainder of this column can be read here. Debate from our panel of economists appears below.

August 8, 2008 2:37am in Credit squeeze | Comment