FED WATCH: FOMC To Hold Rates Tue, Fret About Inflation

December 11, 2006

By Michael S. Derby

A DOW JONES NEWSWIRES COLUMN

NEW YORK (Dow Jones)--Economists universally expect Federal Reserve policy makers will keep interest rates steady at the conclusion of their meeting Tuesday, while signaling a continued level of concern over inflation that will keep alive the prospect of further interest rate hikes.

In doing so, the likely outcome of the meeting will keep central bankers somewhat at odds with bond market expectations that they will be cutting rates at some point over coming months.

Economists reckon the trajectory of recent economic data, coupled with voluminous comments from central bankers, means the Fed will maintain its overnight target rate at 5.25%. That rate has been in place since Aug. 8, and if the Fed meets expectations, it would be the fourth straight gathering at which monetary policy has been left unchanged.

The utter lack of controversy surrounding what the rate setting Federal Open Market Committee will do with monetary policy drives any possible drama to the wording of the Fed's policy statement. Central bankers use that document to briefly sketch out the reasons for their rate actions.

Tuesday's meeting is widely expected to see officials remaining concerned by the level of inflation currently prevailing in the U.S. economy. "They are going to stick to their previous statement" and signal "inflation is more of a concern" than a slowing economy, which signals "a risk" of future rate hikes, said Charles Lieberman, chief economist with Advisors Financial Center in Paramus, N.J.

His expectation of a hawkish inflation line rests on still tight labor markets and ongoing pressure on prices throughout the economy. "I don't see anything that's moderated inflation pressures" since the last Fed meeting, Lieberman said.

Indeed, central bank concern over inflation pressures seems a sure thing. In a speech given at the end of November, Fed Chairman Ben Bernanke called price pressures "uncomfortably high," and added "whether further policy action against inflation will be required depends on the incoming data." Other central bankers have said similar things, thus exposing the depth of the Fed's anxiety.

Many analysts believe the central bank will state its inflation concerns in a fashion similar to recent meetings. That means a replay of the Oct. 25 FOMC statement is highly likely. Then, officials said "readings on core inflation have been elevated, and the high level of resource utilization has the potential to sustain inflation pressures." Expect to see something similarly worded on Tuesday.

The Fed will also offer its assessment of economic growth, and there economists find less to agree on. To be sure, most concur recent months have shown only modest advances. But forecasters' individual levels of alarm are tempered by views on whether the current troubles are temporary, or more enduring. Given the uncertainty over the outlook, the Fed may tackle this subject with even more brevity than usual.

"I don't think the economic outlook today is much clearer than it was last month," said Victor Li, associate professor of economics at Villanova School of Business in Villanova, Penn. "There is still some evidence of a slowing economy," but it remains to be seen what will happen through the holiday spending season, Li said.

Because the Fed's rhetoric will almost certainly point to the threat of higher rates, even as it falls short of ensuring that reality, the statement may cause some friction with Wall Street's various camps.

The bond market has long expected a fairly extensive series of rate cuts, although those odds were pared back somewhat when the government said Friday hiring in November remained relatively robust. Meanwhile, most economists also believe the Fed will trim rates, according to a survey by Dow Jones Newswires. But they see the easing coming later than bond investors, with the funds rate settling to 5% by the end of 2007. That forecast jibes with that of the elite monthly Blue Chip Economic Indicators poll, which sees the same path for rates.

Merrill Lynch economists are more downbeat than the rest of the forecasting community. They told clients "we believe this expansion is getting long in the tooth" and continued housing sector troubles will add enough drag to the economy to drive the Fed cut to 4% by the close of 2007.

On the other side, Advisors Financial Center's Lieberman is part of a small camp that expects the Fed will be forced by inflation to push interest rates up sometime next year. While not many forecasters agree the Fed will move higher, they at least agree that the environment could support such an action. The Blue Chip forecast for the Fed's preferred inflation gauge will leave price pressures above the central bank's understood comfort zone through the coming year.

 (Michael S. Derby, a special writer with Dow Jones Newswires, has covered the Federal Reserve since 2001. He also writes about bond markets and the economy.)

-Michael S. Derby, Dow Jones Newswires; 201-938-4192;