WAR IN THE Middle East; nuclear proliferation; rampant street crime; America run by a wannabe teenage rapper; a British prime minister who longs for initiation as this gangsta’s fawning sidekick and messenger boy. The headlines have certainly been depressing this week, but just wait until the autumn. For American and British voters war and diplomacy are big stories, but they generally affect other people. Before this year is over, the bad news will be hitting closer to home.

Ever since they jointly launched their Iraq adventure, George Bush and Tony Blair have enjoyed another bond that has greatly reinforced their self-righteousness. Whatever setbacks they suffered in geopolitics, they kept winning elections and they did this essentially for the same reason: in the three years since the Iraq invasion, the American and British economies have prospered as almost never before. But this reassuring calculus is now changing, especially in America. And bad news for the American economy would rapidly spread to Britain and the rest of the world.

Without going into the economic minutiae ( I will provide more detail in the Economic View column on Monday) the essential problem can be simply stated: in the past three years America has been enjoying an unusual combination of low inflation and rapid growth. This happy combination cannot continue much longer. In the months ahead, either inflation will continue to accelerate or economic growth will have to slow abruptly, to the point where unemployment starts rising and businesses start going bankrupt.

American voters could soon get a taste of both higher inflation and higher unemployment, bringing back memories of “stagflation”, a simultaneous attack of stagnation and inflation, an ugly buzzword that has hardly been heard in America or Britain for 15 years.

There are two reasons for this gloomy prediction. The first is that evidence of stagflation is becoming visible in American economic statistics and once an inflationary trend is established it is always hard to reverse. The second is that the policies that could avert or quickly cure a bout of stagflation are, in the short term, unpopular and painful. They are therefore unlikely to be implemented by President Bush’s economic appointees, especially with a closely fought congressional election approaching in November.

Let us start with the statistics. The US economy is now clearly slowing, and what started as an orderly retreat in the housing market is turning into a rout. Yet the slowdown in housing and consumption has come too late to prevent a steep increase in inflation. On Wednesday, US government statisticians reported a further jump in inflation to 4.3 per cent. This was the highest inflation rate reported since 1991 (apart from a one-month blip after Hurricane Katrina). And while politicians in Washington routinely play down this “headline” figure because it is allegedly distorted by rising prices, the argument is wearing thin, not only because the reported figure reflects the cost of living as perceived by consumers, but also because the so-called core or underlying inflation figures are also relentlessly on the rise.

In response to recent increases in core inflation, Federal Reserve officials have started arguing that this core inflation figure, too, is exaggerated by statistical distortions in the calculations of housing costs. This is simply untrue. Inflation, far from being confined to a few rogue sectors such as energy and housing, is spreading rapidly through the US economy. Indeed, the Fed’s own calculations show that more than half the goods and services in the typical American’s basket have risen by more than 3.5 per cent in the past 12 months. And on the definition of prices used in Britain and Europe (which includes fuel but excludes housing), inflation in America is now running at a truly alarming 4.8 per cent.

The Fed could, of course, keep changing its definition of core inflation. By removing from the consumption basket any item that is going up, a central bank can always prove that inflation remains under control, but this is an approach to economic management one expects to find in Zimbabwe, not in the US.

This leads to the second reason for concern about the US economic outlook: the refusal of Ben Bernanke, the Fed chairman, to recognise the gravity of the inflation threat and to acknowledge the need for a little belt-tightening to bring the US economy back into balance.

This week, in his semi-annual report to Congress, Professor Bernanke was widely expected to give warning that US interest rates might have to keep rising and that the US economy would certainly have to slow quite abruptly to bring inflation back under control. What he did instead was to promise that the trend of inflation could be reversed without inflicting any pain at all on the American public: “The economy should continue to expand at a solid and sustainable pace and core inflation should decline from its recent level.”

In its numerical forecasts the Fed showed this “sustainable” growth pace as 3 to 3.5 per cent, a growth rate that, significantly, would involve no increase whatsoever in unemployment. And to emphasise that maintaining this rapid growth rate was not just a hope but an explicit objective, Professor Bernanke’s added in his oral presentation: “Clearly, we don’t want to tighten too much to cause our economy to grow more slowly than its potential. We are very aware of that concern. We think about it. We look at it. We try to evaluate it.”

How can the Fed commit itself to price stability and rapid growth? How can it halve US inflation from 4.5 to 2 per cent without allowing even a brief period of rising unemployment? Professor Bernanke offered no answers. If he performs these miracles, he will go down in history as an even greater financial wizard than Alan Greenspan. If he fails, he may be likened to another Bush appointee who promised painless victories without much idea of how to achieve them. Is Ben Bernanke the Fed’s Donald Rumsfeld?

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