At crossroads, Fed expected to hold fire

WASHINGTON – The Federal Reserve, seeing its predictions on cooling economic activity and inflation come to reality, is widely expected to keep interest rates unchanged at its meeting Wednesday, analysts say.

Economists say that while the battle against inflation is not over, the trend points to an easing of inflationary pressures that will allow the central bank to maintain its base rate of 5.25 percent.

The Fed in August announced a pause after 17 consecutive rate increases, saying that any future actions would depend on incoming data.

The latest statistics on inflation appeared to confirm the trend. US consumer prices rose 0.2 percent in August and the widely watched core rate excluding food and energy increased at the same 0.2 percent pace.

“The second consecutive monthly core inflation reading of 0.2 percent signals the beginning-of-the-end for the broad-based acceleration in core consumer prices that began last March,” said Kenneth Beauchemin, economist at the research firm Global Insight.

The inflation data “provides a measure of vindication for the Fed’s decision to place its two-year credit tightening campaign on hold to accumulate information,” Beauchemin added.

“Indeed, the likelihood of further rate hikes is falling.”

Moreover, analysts say the sharp drop in energy costs in recent weeks will show up in future data, result in even tamer inflation figures.

“Slowing economic growth, falling housing prices, and falling oil and natural gas prices should relieve pressures on both the energy and core price index,” said Peter Morici, an economist at the University of Maryland.

“Inflation should cool significantly in September and October.”

The US economy cooled to a 2.9 percent annual rate in the second quarter, down from 5.6 percent in the first quarter.

“The slowdown in US economic growth is helping cool price pressures, which should keep the Fed on the sidelines next week,” said economist Jennifer Lee at BMO Nesbitt Burns.

Some analysts say the slowdown will become even more pronounced in the coming months, making it likely that the Fed’s next move will be to cut rates.

“In combination with a slowing US economy, we continue to stand by the belief that the Fed will be forced into cutting interest rates in early 2007,” said Eric Lascelles, analyst at TD Bank Financial Group.

Some analysts say the conventional wisdom is wrong, and argue that high energy prices have in fact kept inflation in other areas in check by limiting consumer spending power. They argue that the drop in energy prices could lead to more consumer spending, and thus higher inflation. “While it is a close call, in today’s environment we believe the drop in oil prices argues for a more hawkish Fed,” said Ethan Harris, chief US economist at Lehman Brothers, who is predicting rates as high as 5.75 percent early next year.

“The weakening of energy prices could have a relatively quick impact on consumer spending, particularly for low-end ‘hand-to-mouth’ consumers. This could push GDP growth above 3.0 percent in the fourth quarter. This combination of a quick boost to growth, but only a slow benefit to core inflation, would torpedo the market expectation of rate cuts in the coming quarters.”