Forget talk about surging inflation. The real risk now is economic contraction. By Steven Goldberg, Contributing Columnist March 15, 2011 With prices of food and energy up, you can be forgiven for joining the chorus of investors fretting about inflation. But the real risk to the economy isn't inflation at all -- it's a double-dip recession. Japan's triple tragedy -- an earthquake, a devastating tsunami and now a potentially catastrophic nuclear meltdown -- increases the dangers significantly.The massive dislocations in Japan pose real risks to its banking system -- and, perhaps, even the global financial system. Many Japanese companies are shut down, 40% of the nation’s electrical power is off line, and ports are crippled. That means many more loans will go unpaid, and Carl Weinberg, co-chief economist at High Frequency Economics, worries that Japan’s banks may be unable to stand the new strains. "If Japan’s banks fail because their 'assets' have been wiped out by last week's disaster, what does that mean for banks in New York, London or Fankfurt?" writes Weinberg. The disaster in Japan is combining with high commodity prices to throw a monkey wrench into the economic recovery. In the U.S., high prices for food and fuel are pinching consumers. After you pay more for your groceries and to fill your gasoline tank, can you ask for a raise? Just try it with the unemployment rate at 8.9%. Weinberg has it right. "An inflationary spiral can only occur if wages rise in tandem with prices," Weinberg writes in a note to clients. And wages can’t rise when unemployment -- not only in the U.S. but also in Japan and much of Europe -- is at sky-high levels. Advertisement In the 1970s, oil shocks brought us both inflation and recession -- a painful combination aptly named stagflation. But the situation then isn't all that similar to where we are today because wages in the '70s were indexed to inflation. Unions negotiated contracts that insulated employees from the ravages of inflation. "If the consumer price index rose by one percent, wages would automatically be increased -- sometimes monthly -- by at least one percent," Weinberg writes. Today, Luxembourg and Belgium are about the only countries where wages are indexed to inflation. Wages in the U.S. in February were unchanged from January, according to the unemployment report released early in March. And pay raises elsewhere across the developed world have been scant over the past few years. So when consumers pay more for food and energy, they're forced to cut their spending elsewhere. That's what's occurring in the U.S. today because of surging gasoline prices. "It is a deflationary shock, reducing aggregate demand and putting downward pressure on the majority of prices," Weinberg writes. The crisis in Japan raises the deflationary risks. Japan is the world's third-largest economy and fourth-largest international trader, supplying goods, such as semiconductors, used by companies worldwide. "Prospects for the global economy have been smacked by the disaster in Japan," Weinberg writes. "The outlook has been reduced for almost every company in the world that does business with Japan, as well as for companies in Japan itself." Advertisement The Danger of Higher Oil Prices Think of the increase in oil prices as akin to a tax increase. Rising oil prices may have already undone much of the economic benefit of the two-percentage-point cut in this year's Social Security payroll taxes. Ian Shepherdson, the other co-chief economist at High Frequency Economics, estimates that U.S. gross domestic product will be reduced by 0.5% if oil prices average $100 a barrel over the next 12 months. That, he writes, would be "unwelcome but not catastrophic against a backdrop of an economy which otherwise would likely have expanded by 3% or more." The oil shocks from the Middle East are one more reason that the Federal Reserve is sticking to its extraordinarily loose monetary policy. Fed Chairman Ben Bernanke wants to see a core inflation rate (inflation without the volatile food and energy components) of 2%, and he wants to see unemployment decline sharply. Advertisement William Dudley, president of the New York Federal Reserve Bank, echoed those sentiments in a recent speech. "Barring a sustained period of economic growth so strong that the economy's substantial excess slack is quickly exhausted, or a noteworthy rise in inflation expectations, the outlook implies that short-term interest rates are likely to remain unusually low for an extended period," he said. The desire by Congressional Republicans to attack the budget deficit by cutting federal spending could hurt the economy, at least short term. Bernanke has repeatedly endorsed increased short-term spending to help stimulate the economy. Now the inflation hawks on Wall Street and in Washington certainly have reasons to be concerned. The Fed has added more than $1 trillion to the economy to make up for the scarcity of bank lending and corporate and consumer spending. Bernanke and his colleagues will have to be prescient on when and how they reel that money back out of the economy. If they’re too slow, we could well see high inflation, as well as a steep decline in the dollar. And the federal debt poses enormous dangers over the long term to the U.S. economy. As the economy continues its recovery, spending will have to fall (or at least rise at a much slower rate), and taxes will have to rise. Before rallying as a result of the Japan crisis, the bond markets were already showing signs of being spooked over inflation. Should the "bond vigilantes" -- the big traders who dominate the bond market -- turn bearish in a big way, bond yields would surge (they have come down during the recent rally). That would choke off borrowing and could trigger another recession. Advertisement But inflation is not the risk to the economy today. Today the big risk is that the bond vigilantes, or, far more likely, a huge oil-price shock knocks the economy into another recession. I think that's unlikely, but it's what I lose sleep over these days. Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.