For Fed officials, timing is everything
A division in the ranks about when to raise rates
HARWICH - After several months of aggressive interest rate cuts, the struggling US economy will have to climb out of the current economic downturn without much more help from the Federal Reserve.
As top Fed officials made clear at an economic conference here last week, the central bank is increasingly worried that soaring energy prices will ignite inflation across the broader economy. In a series of speeches, including one by chairman Ben S. Bernanke, Fed officials acknowledged the threat of an inflationary cycle taking root and underscored their determination to snuff it out.
That undoubtedly means the Fed has stopped cutting interest rates, analysts said, with its next move likely a rate increase. When that might come remains unclear, but timing is critical. Wait too long, and inflation could spin out of control, as in the 1970s. Tighten credit too soon, and the slumping housing market and still weak economy could slide further, extending the current downturn.
For the time being, it appears Fed officials are divided on how quickly they need to raise rates as they face a weak economy and rising inflation simultaneously. Typically, a weak economy means lower inflation because it cuts demand and makes it harder for businesses to raise prices. The last time policy makers faced a similar situation was the '70s, when soaring oil prices contributed to stagnant growth and double-digit inflation, giving rise to the term, "stagflation."
At the Cape Cod conference, for example, Bernanke talked very tough on inflation, leading some analysts to project a rate increase as early as the fall. Boston Fed president Eric Rosengren, however, cited research indicating that oil price shocks have little effect on long-term inflation, suggesting the Fed could afford to hold rates lower for longer to allow the economy time to mend, analysts said.
Donald L. Kohn, the Fed's vice chairman, said the Fed will have to strike a balance between inflation and growth, and avoid one-sided approaches that could lead to "extreme outcomes" in either inflation or unemployment. In the short term, he said, policy makers might have to accept higher inflation and unemployment above their normal comfort level.
"There's a wide range of views at the Fed, wider than I can remember," said Mark Zandi, chief economist at Moody's Economy.com in West Chester, Penn. "It goes to the difficulty of the situation."
Analysts and markets likely will get a better idea of the policy makers' thinking next week when they meet to set interest rates. The Fed is widely expected to leave rates unchanged, but the statement they release describing current conditions and their view of risks to the economy could suggest how the Fed might act later.
At the Cape Cod conference, Fed officials signaled that inflation, rather than economic weakness, has become their main concern. Ideally, analysts said, policy makers would like to hold interest rates at the current level and give the economy more time to recover before raising rates.
Christopher Probyn, chief economist at State Street Global Advisors, a unit of State Street Corp. of Boston, said that holding steady seems a likely course. The weak economy, Probyn said, should moderate inflation. "The Fed is on hold for the foreseeable future," he said.
In the meantime, Probyn said, the Fed is "talking tough" to keep inflation expectations in check. Ultimately, analysts said, the Fed isn't concerned about soaring oil prices boosting short-term inflation, but rather that they will lead consumers and businesses to expect prices of many goods and services to keep rising over the long term.
If consumers expect inflation to remain high, they buy more in advance to avoid price increases, adding to demand and pushing prices even higher. In addition, workers might demand higher wages to offset increased costs of living, leading producers to increase prices even more. That's called a "wage-price spiral," and it was a key component of the runaway inflation of the '70s.
There's little evidence a wage-price spiral is underway, in large part because of economic changes since the '70s, including weaker labor unions and increased global competition. But inflation expectations appear on the rise: A recent survey by the Conference Board, a nonprofit research group in New York, showed consumers' inflation expectations at the highest level in more than 20 years.
Still, said Scott Anderson, senior economist at
Robert Gavin can be reached at rgavin@globe.com. 
