With inflation monster tame, Fed can manage risk

With inflation pressures relatively tame for now, the Federal Reserve appears to have a wide-open window to pursue a "risk management" interest rate policy that insures against a steep economic downturn created by the housing market slump.

Recent mild inflation data has been applauded by policy-makers, and even as the dollar sags and crude oil prices climb many Fed watchers guess that inflation will stay contained by anemic economic growth.

"The cost of cutting with regard to inflation risk is low, but the cost of doing nothing in terms of economic growth may be high," said Cyril Beuzit, economist at BNP Paribas.

The Fed's Open Market Committee meets Tuesday and Wednesday to decide its next move. In September, the central bank surprised markets with an aggressive 50 basis point cut in the federal funds rate, its first in more than four years. That took the key lending rate to 4.75 percent from 5.25 percent.

Financial contracts handicapping expectations on Fed rate policy show a one-quarter basis point rate cut is fully priced for the upcoming meeting, with another half-point move not out of the question.

Fed Chairman Ben Bernanke is thought to favor the increased "juice" that the bank can get from markets if it does more than simply match expectations with policy moves.

With that in mind, a significant minority of bets has been placed on a 4 percent fed funds rate by year end, or 75 basis points in cuts at the next two FOMC meetings.

Deep into the quarterly earnings season, businesses such as freight-hauling companies are keeping up a drumbeat of talk about recession as the residential housing slowdown drags consumers to the ground.

Housing-related consumption accounts for more than a quarter of total U.S. consumer spending.

On Friday the Reuters/University of Michigan consumer sentiment survey dropped to its lowest level since May 2006 -- the month when U.S. gasoline pump prices made record highs.

The report arguably helped give the Fed a freer hand, with inflation expectations contained despite recent increases in crude oil prices.

Even so, inflation is not gone. Inflation breakevens shown in Treasury Inflation Protected Securities (TIPS) are back on the rise. On Friday 10-year TIPS spreads showed inflation expectations of 2.37 percent, the highest since July.

"Inflation hasn't warranted a place at the top of the trouble table recently, but it bears watching," said Carl Tannenbaum, chief economist at LaSalle Bank. "Certainly (it is) no time to become complacent."

DOLLAR WOES CONTAINED?

The Fed is also grappling with an unprecedented fall in the value of the U.S. dollar.

The import-driven economy appears to run a nagging inflation risk from the greenback's protracted decline. The dollar hit a record low against a basket of currencies (.DXY: Quote, Profile, Research) on Friday and is down about 35 percent since 2001.

But speaking in Los Angeles on Oct 9, San Francisco Fed President Janet Yellen said that so far, the currency's drop has had "surprisingly little impact" on U.S. import prices, as sellers absorb the currency loss to maintain exposure to the vast U.S. market.

September's core personal consumption expenditures (PCE) price index, due for release on Thursday, is likely to be similar to August's year-on-year 1.8 percent.

That would keep the key inflation gauge within the 1 percent to 2 percent informal "comfort zone" thought to be favored by some policy-makers.

"A slower economy and additional slack in the labor market should help keep inflation under control. We look for the core PCE deflator to remain essentially flat at 1.8 percent through the end of next year," said economists at Lehman Brothers.

TURNING TAIL?

Still, the possibility of a rate policy U-turn has not been totally discounted.

Charles Evans, the new Chicago Fed President, this week addressed the potential for a change in course if the "worst case scenario" does not play out for the economy and inflation ticks higher. "I would see any increase in inflation or inflation expectations from their current levels as a serious concern," Evans said.

Recent forecasts from the San Francisco Fed suggested that the current quarter will mark the low for U.S. economic growth, and that activity would bounce back modestly in 2008.

This week, the three-month average of the Chicago Fed's national activity index for September marked 13 consecutive months in negative territory.

At -0.31, September's index was the lowest since March but still far short of the -0.70 level thought to signal that recession is at hand.