Among the world's two major central banks, the Federal Reserve is stuck somewhere between steps one and two, while the European Central Bank is firmly residing at the second option, warning that it might advance to the third.
At 4 per cent, the US inflation is threatening to undermine the credibility of a central bank that has cut interest rates seven times to 2 per cent from 5.25 per cent over the past eight months in an attempt to keep the $13 trillion American economy growing.
Meanwhile, the ECB has left the rates unchanged at 4 per cent since June 2007. Euro-area inflation was 3.3 per cent in April, compared with the ECB's target of just below 2 per cent. In March, the rate was 3.6 per cent, almost a 16-year high.
The dilemma for investors is whether prices will climb still higher or whether slowing growth and the credit crunch will slay the inflation dragon.
"Getting this question right is critical: It not only has important long-term implications for all investment markets but also impacts how the current crisis will play out,'' said Chen Zhao, Montreal-based global strategist for BCA Research.
Investors seem confused. A third of the money managers attending Morgan Stanley's global credit conference in Venice three weeks ago listed inflation as their No 1 concern. Three- quarters of those polled said they expected US headline inflation, which includes energy and food, to average 3 per cent or more over the next five years.
At the same time, the pros were pessimistic about the outlook for the US economy. They also didn't buy the thesis that Europe and China could escape the fallout from a weakening American economy.
What's more, the five-year breakeven inflation rate from the US Treasury Inflation Protected Securities market, which reflects both a forecast of consumer prices and a volatility estimate, is just 2.3 per cent.
The good news is that inflation may not turn out to be as bad as the pessimists think. The bad news is there's probably not much that central bankers can do to control it anyway.
It's important to differentiate between a general increase in prices
