With the global recession finding a bottom, central bankers must choose one
of two starkly different historical lessons to bring to the mother of all policy debates – the question of when to unwind their extraordinary stimulus measures.

Should they worry about repeating the mistakes that produced U.S. inflation
in the 1970s? Or those that fueled Japan’s deflation in the 1990s?

Inflation hawks believe the current situation, including high oil prices, is
analogous to the 1970s, a period in which lax U.S. monetary policy produced
both high inflation and unemployment. It took almost a decade – and then
Federal Reserve Chairman Paul Volcker’s brutal, unrelenting rate hikes – to
kill the stagflation scourge.

Philadelphia Fed President Charles Plosser placed himself firmly in the
hawks’ camp in an interview with The Wall Street Journal and Dow Jones
Newswires on Monday. Warning that rates may need to rise from their near-zero levels in the “not-too-distant future,” Plosser said he didn’t “want to repeat the Great Inflation of the 1970s,” when high unemployment proved to be no bulwark against rising prices.

But on Tuesday, one of Plosser’s more dovish counterparts on the Federal Open Market Committee referenced Japan to rebut the argument that big U.S. fiscal deficits will create inflation unless the Fed tightens monetary policy.

“Japan has had huge deficits through much of the past two decades,” said
Janet Yellen, president of the San Francisco Fed, “yet its problem is
persistent deflation – precisely the opposite of inflation.”

This hawk-versus-dove dynamic exists around the world, too.

Two weeks ago, Adam Posen, the newest appointee to the Bank of England’s
Monetary Policy Committee, justified quantitative easing in the U.K. by warning
against repeating the Bank of Japan’s premature tightenings in the mid-90s.

On Tuesday, however, Reserve Bank of Australia Governor Glenn Stevens said
the downturn in his country looked modest by historical circumstances and
signaled that rate hikes could be coming to Australia sooner than people think.

It boils down to the different triggers behind each country’s current
economic malaise. Those differences demand contrasting readings of history.

Relative to the U.S. and U.K., Australia’s banks are in reasonable shape and
retail sales have held up well. Its economic downturn was caused by
deteriorating demand and prices for its key commodities.

Now that commodity prices are recovering, it is inevitable that RBA’s Stevens
“can much more easily imagine upside risks to the outlook,” as he said Tuesday.
As with oil during the 1970s in the U.S., commodity prices in Australia run the
risk of feeding into inflation.

By contrast, the U.S. and U.K. recessions have their roots in a domestic
banking crisis prompted by the bursting of the housing bubble. This is feeding
a vicious cycle of rising unemployment and falling consumer spending – evident
in Tuesday’s drop in the Conference Board’s consumer-confidence index even as
other indicators point to a tepid inventories-led recovery in manufacturing.

That story should sound familiar to policy makers in Japan, where the 1990s
commercial real-estate collapse left the country’s banks in a zombie state,
unable to lend. Without credit, Japanese consumers stopped spending, so much so
that they began postponing purchases in expectation of future price declines,
creating a destructive, self-perpetuating deflationary spiral in the process.

Let the Aussies worry about America’s past stagflation mistakes. The Fed
needs to avoid Japan’s deflationary blunders.