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Fed, battling on two fronts, leaves rates unchanged

The central bank acknowledges that it needs to be vigilant against both economic decline and inflation.

June 26, 2008|Peter G. Gosselin | Times Staff Writer

WASHINGTON — For nearly a year, the Federal Reserve saw one clear and present danger to the U.S. economy -- the roiling credit crunch -- and responded by slashing interest rates more aggressively than at any time in two decades and by weaving an extensive safety net for the nation's financial system.

But Wednesday, Fed officials were forced to acknowledge that they faced a new and trickier problem: a two-front fight to keep the economy and financial markets from sinking while also stopping prices from skyrocketing. The central bankers' response: Stand pat.

For the first time since the crisis began last summer, Fed policymakers left their key interest rate unchanged at a low 2% and issued a tepid statement saying they'd be on guard against both economic decline and an inflationary price surge.

"They've decided their best option is to speak loudly and carry a small stick," said Mark Vitner, a senior economist at Wachovia Corp.

The difficulties facing the central bank begin with the fact that propping up a sagging economy and shaky financial markets demands low interest rates, while tamping down spiraling prices calls for high rates.

But that's not where the difficulties end. Because the prices that are rising most rapidly and that threaten to drag the cost of almost everything else up with them -- those for food and fuel -- are largely set in world markets, they are beyond the immediate reach of the U.S. central bank.

As a result, if Fed Chairman Ben S. Bernanke and his colleagues are forced to tackle inflation, they may have to crank up rates much higher than they would if the problems were entirely domestic.

As the credit crunch, the housing slump and plunging consumer confidence push the economy toward a slowdown, booming growth in such places as China, India, Russia and Brazil is driving up food and fuel prices, said Nariman Behravesh, chief economist of the Boston-area forecasting firm Global Insight.

"This state of affairs puts . . . the Federal Reserve in a very awkward spot," Behravesh said. "Economic growth is likely to remain very weak for the next year while headline inflation will likely keep rising."

Amid such crosscurrents, the Fed's decision Wednesday may be smart, some analysts said.

Indeed, in their statement Wednesday, Fed officials indicated they hoped that the economy's biggest problems would work themselves out, rather than require further Fed action.

The statement said that "overall economic activity continues to expand, partly reflecting some firming of household spending."

This was a somewhat sunnier assessment than the Fed issued in April when it suggested the economy might be contracting outright.

It was especially notable coming only a day after the Conference Board, a business research group, said that by some measures consumer confidence was at its lowest ebb on record. Analysts consider low confidence to be a precursor to a cutback in consumer spending.

In their statement, Fed officials said they expected inflation to "moderate later this year and next year." But they warned that "in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations," the danger of still more inflation remains high.

Rising inflation expectations are a special worry for central bankers because they signal that people have begun to assume that prices are on the way up and therefore that they should charge more for their labor or products. That is a recipe for setting off a vicious cycle of higher prices feeding still higher ones.

"Initially, everybody thought the run-up in food and fuel prices was temporary. But the longer it lasts and more people start thinking it's permanent, the more the increase will bleed over to other prices," said Gregory D. Hess, an economist and vice president for academic affairs at Claremont McKenna College. "That was the story of the 1970s."

Analysts said the Fed indicated that it was shifting its focus away from the danger of economic decline and toward inflation and that if prices don't stop rising sharply on their own, the central bank will step in with higher interest rates.

"There's no question that . . . Bernanke and his colleagues have switched gears," said veteran Fed watcher David M. Jones, who heads an economic consulting firm based in Colorado and Florida. "The next time the Fed changes rates, it will be to increase them."

Jones predicted that the central bank would not act until after the November election.

Wednesday's rate decision came on a 9-1 vote. Richard W. Fisher, president of the Federal Reserve Bank of Dallas, was the lone dissenter.

He called for an immediate rate increase.

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peter.gosselin@latimes.com

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On latimes.com

Fed statement

For the complete text, go to latimes.com/fedtext

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