Inflation fears might hasten Fed's hand

By SHIHOKO GOTO, UPI Senior Business Correspondent  |  March 14, 2005 at 3:13 PM
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WASHINGTON, March 14 (UPI) -- There's nothing the Federal Reserve dislikes more than volatility in the marketplace.

But oil prices continue to rise and many analysts expect energy costs to climb still further in coming months giving the Fed no choice but to jack up interest rates more quickly than they wanted to. Meanwhile, analysts have become increasingly jittery about the value of the U.S. dollar sliding still further as Asian central banks in particular are beginning to sell off more of their greenback holdings.

Until now, though, the central bank policymakers have been able to tighten monetary policy more or less on their own terms, and the equities market has been climbing on an even keel without raising any red flags, either to the bulls or to the bears. Since June 2004, the Fed has been inching up rates by 25 basis points each time they meet, bringing up the benchmark federal funds target rate to 2.50 percent by February.

But while most economists expect the Fed to keep raising interest rates by another quarter-percentage-point when policymakers next meet March 22, the question remains whether the central bank will indeed be able to tighten policy "at a pace that is likely to be measured" in coming months. The single biggest wild card is the prospect of higher oil prices, while concerns about the dollar's value falling still further looms ever larger.

To date, the economy as a whole has been able to absorb the climbing energy costs, even as the price of crude oil continues to remain above $50 per barrel despite concerted attempts from the Organization of Petroleum Exporting Countries to bring it back down. But while prices at the pumps remain high and prove to be a major headache for drivers, it appears that energy costs are not yet making a significant dent on consumer spending. Moreover, businesses have proved that they do not yet need to pass on the higher production costs onto their customers due to fierce global competition to produce cheaper goods.

As for the greenback's value, analysts have been concerned about the growing trend of Asian central banks in particular selling off dollars. Indeed, the Bank for International Settlements reported earlier last week that Asian central banks on average cut back their dollar exposure to 67 percent in September 2004 from 81 percent three year earlier. Meanwhile, Japanese Prime Minister Junichiro Koizumi told lawmakers in parliament last week that Japan, which holds the biggest foreign reserves in the world, should consider reducing its dollar holdings. A further sell-off of dollars by foreigners would not only decrease the value of the greenback, but would also lead to a fall in the value of U.S. assets as well, which in turn would hurt the U.S. economy's growth prospects.

So with the possibility of higher oil prices coupled with a further decline in the greenback's value, central bankers are having to grapple with fundamental issues affecting the U.S. economy that they by and large have no control over.

Nevertheless, analysts are getting increasingly anxious that the current circumstances of steady growth with little inflationary pressure is not sustainable and indeed, the bond market has already started taken into consideration since last week the possibility of higher inflation resulting as a result of climbing energy costs.

"The bond market had a rough week (last week), as investors became concerned that inflation might perk up, the Fed might drop its 'measured' phrase, and foreign central banks might diversify out of their dollar holdings," said Charles Lieberman, chief investment officer at Advisors Capital Management and former economist at the New York Fed.

That view was echoed by Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson, a Chicago-based investment bank.

"The wind is starting to blow hard and the anchor is drifting," Wesbury said, adding that Fed policymakers are "continuing to wrestle with language about a 'measured pace'".

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