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The Honolulu Advertiser
Posted on: Sunday, August 17, 2008

Fed risks recession if it raises rates, higher inflation if it doesn't

By Kevin G. Hall
McClatchy-Tribune News Service

WASHINGTON — The job of the Federal Reserve and government policymakers got more complicated last week when the Labor Department reported that consumer inflation is running at an annual rate of 5.6 percent, its highest level in 17 years.

The Federal Reserve has been worried about inflation for months. But it has left its benchmark federal funds rate at 2.0 percent since April, betting that inflation pressures will ease when energy prices fall back.

Oil prices are off more than $30 from their peak of $147, yet the Bureau of Labor Statistics said Thursday that consumer prices soared 0.8 percent in July, twice the rate that most economists had expected.

Even the core inflation rate, which excludes volatile food and energy prices, exceeded expectations by jumping 0.3 percent to a 12-month rate of 2.5 percent.

Thursday's numbers deepen the Fed's dilemma. If it raises interest rates to quell inflation, it risks tipping the fragile economy into recession. If it allows inflation to gather steam, it loses its credibility as the firewall that protects consumers and businesses from the corrosive effects of inflation.

"The Fed is in the same uncomfortable position as it has been for months — caught between a weak economy and elevated inflationary pressures — only more so," said Kenneth Beauchemin, an economist with forecaster Global Insight.

In a research note for investors, he added, "We continue to expect the Fed to hold the fed funds rate at 2.0 percent into 2009."

That means that rates would remain the same in the Fed's September, October and December rate-setting meetings.

What's unusual about this economic downturn is that the federal funds rate, which influences the prime rate and a host of other lending rates for consumers and businesses, is low by historical standards but isn't having the positive effect that it typically has.

That's because the crisis in the housing sector spilled over into the financial sector, and banks have sharply tightened their lending to consumers for homes, cars and even college tuition.

Meanwhile, prices for consumers keep surging, pushed up by this year's run-up in the prices of oil, natural gas and a wide range of other commodities.

Thursday's soaring numbers reflect the third consecutive month of super-sized inflation. Inflation in June jumped 1.1 percent, on top of May's 0.6 percent increase.

For consumers, an annualized inflation rate of 5.6 percent means that they'd need to see their wages increase by that amount just to break even with rising prices.