Thursday, February 21, 2008

Rising Inflation Limits the Fed as Growth Lags


Matters look dim right now with the economic forecast reminiscent of the 70s stagflation. The Federal Reserve appears in a quandary about what to do. "Certainly inflation is nowhere near the double-digit rates of the late 1970s, and many economists agree with Fed officials that inflation will cool as the economy slows.

But the combination of rising prices and stalling growth, aggravated by the deepening downturn in housing and credit markets, has put the Fed in a box of its own making." -Dra. Valenzuela



Rising Inflation Limits the Fed as Growth Lags
By EDMUND L. ANDREWS and MICHAEL M. GRYNBAUM
Published: February 21, 2008
WASHINGTON — The Federal Reserve, for all its power, faces tough new limits on its ability to keep the economy out of a recession.

Even though the Fed cut short-term interest rates twice in January, home mortgage rates have edged up steadily in the last few weeks and credit for businesses is as tight as it was when financial markets seized up last August.

On Wednesday, the central bank, led by Ben S. Bernanke, found itself facing hints of a problem that the United States has not seen in decades: stagflation, the mix of slumping growth, sharp spikes in oil and food prices and a rising pace of overall inflation.

The Labor Department reported that consumer prices jumped 4.3 percent in January, compared with one year earlier. That was the biggest jump in more than two years. Even after excluding the volatile prices for food and energy, inflation was up 2.5 percent — well above the central bank’s unofficial target of 1 to 2 percent.

A few hours after the report on consumer prices, Fed officials acknowledged that they had reduced their forecast for growth this year to an anemic pace of 1.3 to 2 percent and that joblessness was likely to climb to 5.3 percent, from 4.9 percent today.

The Fed’s outlook helped propel the stock market higher on the expectation that the central bank’s more dismal outlook for the economy would lead to further interest rate cuts aimed at reviving growth. After being down earlier, the Dow Jones industrial average closed up 90 points, or 0.73 percent, to 12,427.26, while the Nasdaq composite index erased an earlier 0.6 percent loss to end 0.9 percent higher.

The Fed’s new forecast, however, assumes that growth will be all but stagnant for the first six months of this year before the economy gets a lift in the second half from the economic stimulus package Congress recently passed, as well as from the Fed’s own decisions to lower interest rates sharply.

Certainly inflation is nowhere near the double-digit rates of the late 1970s, and many economists agree with Fed officials that inflation will cool as the economy slows.

But the combination of rising prices and stalling growth, aggravated by the deepening downturn in housing and credit markets, has put the Fed in a box of its own making.

On one hand, officials are cutting interest rates in order to keep the economy growing at a time when oil prices are surging, credit is tightening and major financial institutions are shell-shocked from the housing and mortgage busts.

On the other, the fear of rising inflation makes it more difficult for Fed officials to jolt the economy with another wave of cheap money. Lower interest rates have already pushed down the value of the dollar, which in turn prompted oil-producing countries to push for higher oil prices.

“They are walking a very fine line right now,” said Stephen G. Cecchetti, a professor at Brandeis International Business School. “They are trying to maintain their low-inflation credibility at the same time they are dramatically cutting interest rates. The facts are that growth is falling quickly, and that inflation is high and rising.”

Nowhere have the Fed’s limitations been more apparent than in the home mortgage market. Even though the central bank cut short-term interest rates twice in January, in part to stabilize the housing market, investors remained so worried about the longer-term outlook that mortgage rates have edged up steadily in the last three weeks.

“What’s disturbing and scary is that the Fed is doing all the right things — cutting rates, and saying they’ll do more — but it’s not doing anything,” said Michael Menatian, president of Sanborn Mortgage, based in West Hartford, Conn. “We have hundreds of customers who want to refinance, but they’re locked out.”

Fed officials do not see themselves as powerless. The central bank stunned investors by reducing rates twice in January, once at an unscheduled emergency meeting on Jan. 22 and again at a scheduled policy meeting on Jan. 30. Those moves brought the Fed’s benchmark overnight lending rate down to 3 percent.

According to minutes of both meetings, released on Wednesday along with policy makers’ latest economic projections, Fed officials were increasingly worried that plunging confidence in financial markets would lead to a self-fulfilling prophecy of tighter credit conditions, stalled activity in the broader economy and even more fear in financial markets.

Edmund L. Andrews reported from Washington, Michael M. Grynbaum from New York

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