WASHINGTON—The Federal Reserve is expected to pause Tuesday after 17 consecutive interest-rate hikes, ending a streak of credit tightening that has lifted short-term lending rates from 1 percent to 5.25 percent since June 2004.
Still, analysts warn that the Fed may raise rates in the months ahead if signs persist that inflation is growing worse. Countering that threat, however, is the risk that further rate hikes could tip the slowing economy into recession.
As Fed policy-makers on the rate-setting Open Market Committee weigh the competing risks on Tuesday, they're expected to pause to buy time for more data to accumulate and show which risk is more threatening.
"They have to weigh the risks of tightening again and doing too much and really hurting the economy, or waiting and risk that inflation climbs a bit higher," said Nigel Gault, chief U.S. economist for Global Insight, a consultancy in Lexington, Mass. "They don't have to decide whether interest rates have peaked."
Fed decisions ripple across the U.S. economy. The Fed sets the federal funds rate, which banks charge each other for overnight loans. That's a benchmark rate for bank loans to consumers and businesses.
Raising interest rates makes borrowing money more costly and thus slows economic activity. That is sometimes necessary to take the steam out of inflation—the rise of prices across the economy—but it also puts financial stress on consumers and businesses, and it costs jobs.
Because it can take six months or more before a rate hike's effect is felt across the economy, the Fed is often uncertain when to stop raising rates. Tighten credit too much and the economy can slip into recession. But fail to tighten enough and inflation can get out of control, distorting economic decisions and forcing much higher rate increases later to subdue it.
Fighting inflation is the Fed's chief mission, and just about every measure of inflation is running higher than the 1 percent to 2 percent annual rate that is thought to be the Fed's comfort zone. Soaring energy prices and high commodity prices are driving the current bout of inflation, and wage and benefit costs are rising worrisomely fast as well.
The inflation risk from energy costs continues to grow. British Petroleum shut down an Alaska pipeline Sunday that pumps 8 percent of daily U.S. oil production. BP said the pipe may be shut for months in order to repair corrosion. That sent crude oil prices up about $2 a barrel to $76.98 per gallon on the New York Mercantile Exchange. Gasoline pump prices could jump another dime this week.
In addition, the heart of hurricane season is only weeks away, threatening oil production in the Gulf of Mexico.
Nevertheless, investors are betting that the slowing economy will make the Fed pause. The U.S. economy grew at only a 2.5 percent annual rate between April and June, sharply slower than the previous quarter's 5.6 percent rate.
The slumping housing sector is largely responsible, as new-home starts, existing-home sales and home-equity loans all declined. Rising interest rates hurt all three.
The job market is hurting, too. July's non-farm payroll jobs grew by just 113,000, well below expectations, as the unemployment rate rose to 4.8 percent from 4.6 percent.
"When you combine all the economic indicators out there ... one conclusion is clear. The economic expansion is noticeably winding down. We believe so will inflation," said Bernard Baumohl, executive director of The Economic Outlook Group, a consultancy in Princeton, N.J., in a note to investors. "The right decision for the Fed now would be to pause at this juncture at 5.25 percent."
The Fed's next decision on rates will come Sept. 18, and troubling wage trends may influence it. Real wages jumped 5.7 percent in June.
"Faster labor cost growth makes it harder for firms to hold prices stable, putting upward pressure on inflation," researchers at Goldman Sachs & Co. warned Friday.
The Labor Department will issue new labor and productivity data on Tuesday.
"Even as the Fed is pausing, they may also be seeing some more labor-cost inflation," said Phillip Neuhart, an analyst with Wachovia, a banking giant based in Charlotte, N.C. "We think they are going to leave the door open for possible hikes in the future. One of the reasons they would leave the door open is fear of wage inflation."
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(c) 2006, McClatchy-Tribune Information Services.
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