Challenging times and difficult choices. The prospects for the US economy continue to be a principal focus of attention for investors around the world. And, of course, problems in the financial system, particularly in the United States, are also a source of worry - and rightly so.

The latest set of data releases in the US is far from encouraging. They depict an economy that is experiencing both a slowdown in production and rising inflation. This is an ugly combination, and it is obvious that it makes the policymakers' task very difficult indeed.

We have always been in the camp of those who believe that in terms of the trade-off between growth and inflation, the Fed would go for higher growth at the cost of stoking inflationary pressures. The evidence of their policy decisions supports this contention.

It should also come as no surprise that we have little confidence in the ability of policymakers to fine-tune the economy. Harking back to better times, the smooth functioning of the economy had a lot to do with a felicitous combination of favourable factors and little to do with the policy skills of the authorities. Unfortunately, currently we are facing some of the most challenging circumstances in a very long time.

Of course, it is in the interests of Wall Street, the Fed and the government to downplay the dangers to the economy and the financial system, and to give the impression that they are in control. Many observers are aware of how much spin there is, and discount the verbiage, often heavily.

It is worth repeating what we said previously - that economic fundamentals in the US are quite different from what they were, the last time the economy entered a period of substantial slowdown in 2001. At the time, a number of factors were still supporting a high productivity growth rate, which is not the case today. House prices were still low and the housing industry was ready to enter a boom period. The contrast with present circumstances is too obvious to need mentioning.

Overall, commodity and oil prices were moderate, whereas now there is a danger that they will accelerate if output does not slow down. As for inflation, it was contained, and expectations were for it to stay that way. Currently, data releases point to higher inflation. And while in the earlier period interest rates were expected to stay low for a long time, such is not the case today.

The rise of emerging economies and the spread of globalisation had a beneficial effect in boosting output and capping inflation. Now, rising demand from manufacturers and consumers in these fast-growing economies is having an inflationary effect on energy, industrial and agricultural commodity prices.

In addition, the US fiscal deficit has continued to widen during the boom years and now constrains policymakers' ability to increase government expenditure substantially to compensate for weak private-sector spending. As for the external deficit, it remains exceptionally wide, increasing the risk that funding it may become more expensive.

House prices are still falling and foreclosures are rising. The glut of unsold homes will continue to put downward pressure on prices. Some potential buyers are speculating on even lower prices and will delay purchasing until they get a better deal. Others cannot enter the market because they no longer qualify for mortgages. Gone are the days of easy-to-get, pre-approved mortgages with which households were inundated.

Housing-market adjustments take a long time to work out, if past historical experience is a guide. And this particular housing bubble has been a big one. So it seem likely, according to the experts in this field, that the housing slump will continue for the rest of this year and possibly extend into 2009 before a genuine rebound will take place. Meanwhile, more home-builders will go bankrupt. Apart from the residential market, it is also expected that the commercial property market may face more challenging times.

Borrowing has become harder for households and businesses, as lending standards are tightened. With the prospect of more difficult economic conditions ahead, lenders are wary about extending credit. They are becoming increasingly concerned about conserving capital.

Some of these contentions also apply to the UK and the Eurozone. You may recall that many European banks were highly exposed to the sub-prime melt-down in the United States and suffered the consequences of the ensuing credit crunch. So, the European banks are just as concerned about conserving their capital base and tightening lending standards as their American counterparts.

It is well to note, though, that apart from stretched UK consumers, European households are generally in better financial shape than Americans. And sensitivity to interest rates is often lower in some European countries than it is in the UK and the US. Nevertheless, tighter credit conditions will have an impact.

As house prices fall, so does household net worth. And a wobbly stock market with potential downside does not help either. Meanwhile, the job market is weakening. Hence, it is hardly a surprise that consumer confidence is falling sharply. The consequences are that households will become a lot more cautious.

The stimulus plan brought in by the government, in February, to get consumers to spend more - principally via tax rebates - was not a big one to begin with.

But if a recent survey is anything to go by, gloomy houseBut if a recent survey is anything to go by, gloomy households plan to save most of what they will receive. If that is the case, the boost to economic growth will be modest.

Credit-card issuers, among other lenders, are tightening their standards. And that means some potential spenders can no longer find funding. Furthermore, for those who qualify, interest rates are not coming down in a hurry. Aggressive Fed rate cuts are not being matched by lenders, whose rates remain sticky.

The corporate sector in the US is in better shape than households. But they are a much smaller part of the economy and, given the prospect of greater economic softness, their spending plans are likely to be revised downward. Many firms are banking on growth in the rest of the world to generate demand. But that expectation will pan out only if the US experiences nothing more than a modest growth slowdown.

Even in the fairly robust corporate sector, there are some firms with a heavy debt load, whose profitability is marginal even in good times and will deteriorate in bad times. They are prime candidates for bankruptcy. Vulture investors are waiting for just such bad times. Credit default swaps will also attract attention, though one would do well to consider counterparty risk if conditions really worsen.

The monolines (bond insurers) are still making news. There is great pressure on the credit-rating agencies to maintain the triple-A rating of the monolines. The credit-rating agencies have lost credibility, given their role in the sub-prime debacle, and their opinion is unconvincing, even as they bend under pressure. Grabbing everyone's attention are the umpteen billions of dollars of potential write-downs by the banks if the monolines are downgraded.

Many hedge funds are highly leveraged, and as credit conditions tighten they will face greater risk. Alternatively, they could re-think their strategy, making it more appropriate for current conditions.

Several hedge funds have been forced to liquidate recently, and many more are expected to go bust this year.

In the matter of leveraged buy-out deals, banks are mulling over whether to walk away from their funding commitments or to incur further losses. The issue is whether write-down losses on the loans are greater than the breakup fees. In many cases that is true and, in purely financial terms, it make sense to break their commitment.

They will, of course, also suffer a hit to their reputation. But when you are repairing a balance sheet that is damaged in many places, old formulae may no longer apply.

In a recent statement, Ben Bernanke, chairman of the Federal Reserve, said that some small banks will fail in the current downturn. Others are more pessimistic and think that a big bank may come under threat. Of course, no government can allow a major financial institution to fail because of the obvious risk to the system as a whole.

In the event of an impending bankruptcy a bailout will be arranged, at the taxpayers' expense. Meanwhile, Fed policymakers are trying hard to forestall that eventuality by easing aggressively. However, as we have explained above, the impact of their actions is more limited than they may have hoped for. In addition, there are serious costs involved.

Inflation is rising, and the prospect of even lower interest rates has resulted in a renewed bout of dollar selling. The greenback has sold off sharply against all principal currencies.

The currency of a major debtor nation with a weakening economy, a rickety financial system, a large budget deficit, rising inflation and declining interest rates isn't going to attract buyers in droves.

Gold has hit new highs and there is demand for commodities as an inflation hedge. The worry is that the Fed is now so focused on preventing a recession that it has abandoned any concern about inflation.

Some Fed notables have mentioned that they will quickly reverse interest-rate cuts once the economy is on a solid footing. However, this is total nonsense. They simply do not have the ability to fine-tune the economy, least of all one facing so many challenges.

Headline consumer inflation in the US was up 4.3 per cent in January, year-over-year. And, unfortunately, the forces that are pushing it higher aren't about to dissipate.

If the economy continues to slow down substantially, inflationary pressures will eventually decline. On the other hand, if output picks up, inflation may continue to be a problem. Generally, the inflation rate moves with long lags, and it takes time for the trend to reverse.

The danger is that rising inflation will kick-start an increase in inflationary expectations, which will be even more difficult to reverse. Once entrenched, it will enter into all calculations and an inflationary psychology may take hold.

A market-based measure of expected inflation is the yield spread between ordinary Treasuries and TIPS (Treasury Inflation-Protected Securities). A recent study has found that the spread has risen sharply, from 2.3 per cent at the end of July last year to 3.2 per cent today. It should be noted that the spread has been adjusted for the liquidity premium that ordinary Treasuries enjoy.

Apart from rising expectations, another worrying factor is that uncertainty about future inflation has increased. In other words, even if people do not hold firm views about the future course of inflation, they are willing to shift ground if further evidence surfaces. The Fed is hoping that inflation expectations will not rise and will not becoming entrenched.

Many in the financial markets have been banking on a V-shaped recovery for the US economy.

At least, that is what the price performance of riskier assets has been signalling. More recently, a set of negative data has challenged that view and increased investor doubts.

However, it is still possible that, given the opacity of problems in the financial sector, and the extent of Fed easing, hopes that the US economy will rebound sharply by the fourth quarter, may be revived upon the release of a couple of positive news stories and data prints.

However, we think that slow adjustment in the housing sector and the need to repair problems in the financial system mean that there are many challenges ahead and the most likely outcome is a protracted period of sub-par growth even if the economy escapes a serious downturn initially.

It should be noted that the latter outcome is a distinct possibility.

Limited space precludes an examination of prospects for other major regions of the global economy. Suffice it to say that we have never been adherents of the decoupling thesis.

In closing, let's express some sympathy for the chairman of the Fed, in these difficult times. Mr. Bernanke is not nearly the leader of men that Odysseus was, but he is also forced by fate to chart a course facing the perils of Scylla and Charybdis. Wish him luck.

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Iraj Pouyandeh is a Strategist and Senior Portfolio Manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com