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Take your pick: inflation or recession. Or, if your outlook is especially surly, perhaps you'll opt for choice three: a bit of both, otherwise known as stagflation.

We're not sure which one will prevail and, unfortunately, neither does the central bank. If pressed, our prediction is one of modestly slower growth, which might take the edge off inflation without derailing the economy. The lesser of several evils, if you will. But is that just wishful thinking? Who knows? In times like these, when well-founded assumptions about the morrow fold like cheap cameras, one has to take predictions with an increasingly skeptical mindset. And why not? That's the nature of the future: it's unknown, leaving investors, central banks, butchers and bakers with the unpleasant task of guessing, or forecasting, as it's called in civilized conversations.

But no matter what you call it, the Federal Reserve has no choice but to indulge in it, for better or worse. Even under the best of circumstances, divining the future so as to reverse engineer an informed monetary policy today is a job with more than a trivial dose of risk. With disinflationary winds blowing hard in recent years, the job has looked easy in hindsight. But the jig is up and a far more complicated and risky climate has imposed itself on the business of central banking. Volatility has returned with gale force winds in some corners of the capital markets. The Fed has only a supply of blunt weaponry to battle the storm, but one makes due with the arsenal at hand.

In fact, the Fed has been consumed with tactical issues of liquidity, or the lack thereof, in recent weeks. In response, the central bank has responded with modest but targeted injections of liquidity to stave off what, so far, has been a mostly financial-industry credit squeeze. The Fed's extended credit to those who needed it without lowering interest rates. In other words, the focus has shifted from inflation to recession as a tactical matter. Will the same attitude adjustment now inform the strategic outlook, which would reveal itself as cuts in the target Fed funds rate?

If so, the next question becomes: will long term interest rates, starting with the benchmark 10-year Treasury yield, fall further? Mr. Market has already seen fit to drop the 10-year to under 4.7%, down from an intraday 5.3%-plus back in mid-June. As such, the yield curve is heavily inverted to the tune of 55 basis points. Is that in anticipation of a cut in Fed funds, or just a prelude to more of the same once rumor becomes fact?

If sharply slower economic growth, or worse, is coming, the case for lowering rates soon is persuasive. But if the economy continues bubbling, lowering rates runs the risk of generating more liquidity for an economy that's already suffering from the hangover effects of easy money and loaning money with minimal conditions.

The futures market has already made up its mind, betting heavily that a 25-basis-point cut in Fed funds is on the near horizon. Looking further out, judging by the January '08 contract, Fed funds are projected to fall more, to 4.50% by the new year--75 basis points below the current target rate.

Such cuts are likely to be a timely dose of liquidity that eases the pain of economic slowdown or contraction. But if the economy surprises on the upside, and the mortgage mess stays relatively contained, dropping the price of money runs the risk of creating bigger monetary headaches down the road by fanning inflation's fires. All the more so given the fact that global liquidity is still alive and kicking, as we discussed previously.

The point here is that investors should be aware of the larger context that awaits the Fed, the economy and ultimately the prices of stocks, bonds and commodities. The Fed must make a decision that will affect financial and economic conditions in '08 and beyond. But it must do so with imperfect knowledge of the future. That's always the challenge, of course. The only difference is that the stakes have risen dramatically in recent weeks. Volatility has jumped sharply, elevating the risk that today's choices will bring trouble tomorrow.

Mr. Bernanke, it seems, may have found his defining test as Fed head. If he can successfully navigate the tactical risks in the coming days and weeks, his reputation will soar. For his sake and ours, let's hope he chooses wisely.

Source: Inflation, Recession, Stagflation: Let's Hope Bernanke Chooses Wisely