Editor's Note: In late August, Paul McCulley, manager of the Pimco Short-Term Fund and chief Fed watcher at the big bond fund complex, discussed his contrarian economic outlook with Financial Advisor Editor-in-Chief Evan Simonoff.

Simonoff: Paul, you apparently believe that we're likely to, in the next few years, experience a significant acceleration in the rate of inflation?

McCulley: I think that where we are in inflation right now is not sustainable. Either we're going lower or we're going higher, that we're not going to stay right here. I don't think 1% inflation is aerodynamically sustainable in our economy. The risk to the economy is far more severe if we go down for inflation than if we go up for inflation because if we go down for inflation here, you move into the territory of deflation.

Therefore, I think that deflationary risk will be met by a government response, which is super accommodating monetary policy, very Keynesian fiscal policy and pro-inflation regulatory policy.

The forces of government will be applied to prevent us from going into the land of deflation, which is a matter of arithmetic in some respects. That would be a very positive scenario. As I put it in my writing, if we go down 200 basis points for inflation from here, no one knows how to fix that. However, if we went up 200 basis points, a sophomore macroeconomics student would know how to fix that.

So I think that policy makers, quite appropriately led by the Fed, will consider not just the probability but the consequences of movements in inflation and underwrite a somewhat higher rate of inflation so as to truncate the deflationary risk.

Simonoff: Everybody tells you that virtually no corporations right now have any pricing power whatsoever.

McCulley: Which is a problem.

Simonoff: Do you see this situation healing itself eventually, or do you see it really as being totally driven by the public sector?

McCulley: I think that the Fed would like to see some degree of restoration of pricing power. In fact Greenspan said as much, in a very elliptical way, back in February when he said that it would be good to see corporations be able to take back some of the extreme price discounting of the recession as a means of restoring corporate profit margins.

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