Sharply rising u.s. inflation has spooked financial markets — and with reason. If inflation continues to rise, the U.S. Federal Reserve Board will be forced to push interest rates higher to dampen inflationary pressure. That would increase the risk of a severe economic slowdown or recession.

U.S. core inflation, which excludes food and energy, reached an annualized 3.2% for the six months ended June. This indicates companies are increasing prices to cover rising energy and other costs — and that raises the possibility of “cost-push inflation.”

Cost-push inflation features a vicious circle of workers demanding higher wages to cover the higher cost of living, companies increasing prices to cover those costs, workers demanding further wage increases, prices moving up in tandem, and so on. Already, U.S. average hourly earnings are up 3.8% in June from a year earlier.

But cost-push inflation is not yet established and may yet be avoided. Fed chairman Ben Bernanke argued in his recent testimony to U.S. Congress that the U.S. economy is in transition to a lower-growth path. This is supported by the sharp drop in the leading economic indicator in May and June.

If Bernanke is right, companies will no longer be able to increase prices because they would risk losing market share in the face of weakening consumer demand. This would, of course, result in lower profit margins. But companies can afford that, given that after-tax profits as a percentage of gross domestic product are at historical highs.

This is what the Fed has been aiming at through 17 rate hikes over the past two years.

Welcome as this scenario is, there are risks attached to it. A slowing U.S. economy could trigger significant downward pressure on the U.S. dollar if international investors decide to increase the amounts they put into European and Japanese investments to take advantage of rising interest rates in those regions. The European Central Bank and the Bank of Japan, both worried about the possibility of inflationary pressure, are expected to raise their interest rates in the coming months.

National Bank Financial Ltd. notes that the U.S. needs to attract US$2 billion a day to finance its current account deficit. Any shift in investor geographical preferences would put downward pressure on the US$.

A lower US$ would be beneficial to the U.S. by making companies more competitive in export markets and increasing the cost of imports — as long as it doesn’t fall too far. If the greenback plunges, the Fed would be forced to raise rates to attract the funds it needs — and higher rates could push the U.S. economy into recession.

Canada does not have the same inflation problem. In June, year-over-year core inflation was only 1.7%, less than the median of the Bank of Canada’s 1%-3% target range. Inflation had been pushed down by discounting in advance of the July 1 drop in GST to 6% from 7%. But even without that factor, inflation remains well under control.

However, there are potential inflation problems in emerging markets. Economic growth continues to boom in China, with real GDP up 10.9% in the first half — way above the 8% pace targeted for this year by Chinese authorities. Money supply also exceeded the 16% target, expanding 17.4% in the first six months. If China does not slow its economy significantly in the second half, inflationary pressure could build, particularly now that energy subsidies have been reduced.

There are a number of ways China could slow its economy, including raising interest rates, implementing administrative controls and appreciating its currency.

The risk is that, with little experience in monetary policy, China could do too much and send its economy into a severe slowdown. Growth of just 4%-5% in China would reduce the export volumes of many countries and pull down resources prices. Canada, in particular, would be affected. IE