Eagle statue perched upon the Federal Reserve building in Washington, D.C.
Eagle statue perched upon the Federal Reserve building in Washington, D.C. - 
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Scott Jagow: Yesterday, Goldman Sachs issued it's economic predictions for 2008. Number one: There will be a recession. Number two: The Fed will cut interest rates almost 2 percent by September. That'd be a fairly aggressive move. But the Fed has to be careful, because inflation is lurking. And recession plus inflation equals something truly ugly: stagflation.

Let's bring in our economics correspondent, Chris Farrell. Chris, how aggressive can the Fed afford to be?

Chris Farrell: I think the Fed can go far. Now, yes, you can make a very convincing case that inflation is a worry. But here's what troubles me: There are a lot of mortgages going bad. And it's not just mortgages. Credit card defaults are up, auto loan defaults are up. A number of the big private equity bank deals have fallen apart. And in that kind of environment, where debt is going bad, where the prices in the housing market are falling, that's not an inflationary environment.

Jagow: Well Chris, is there any historical situation that we can look back upon and learn from?

Farrell: Well, we don't have to go back very far in the history books. We've been talking about stagflation in the 1970's. Well what about Japan in the 1990's? This to me is the real concern. Japan in the 1980's, you had a skyrocketing stock market, you had a strong commercial real-estate market. OK, the asset bubble went bust, and Japan went into a stagnation. And it went into a world of very little lending, very low interest rates, and their economy went nowhere. And what happened is that the Japanese Central Bank, when the bubble burst, was fretting, fretting, "Oh, oh, inflation! Inflation's a problem!" Hey, hello, people. There was debt going bad and they didn't act fast enough. So what you don't want to have happen is the Fed worrying about inflation while all this debt goes back.

Jagow: Hmm. So in a sentence or two, what's your prediction for what's going to happen with the Fed this year?

Farrell: My prediction is that the Fed is going to be aggressive, that Ben Bernanke is a student of debt deflation from the 1930's, and that the Fed made a number of studies of the mistakes the Japanese Central Bank made in the 1990's. They're going to be more aggressive than the market thinks.

Jagow: All right. Chris Farrell, our economics correspondent. Thank you.

Farrell: Thanks a lot.