The Fed walks tightrope on interest rates

The mission: slow inflation without causing a slump.

Even as US economic growth appears to be cooling a bit, inflation is not. The pressure of rising prices goes beyond oil, judging by some components of the Labor Department's Consumer Price Index (CPI), released Wednesday:

•Education costs are up at a 6 percent annual pace in the first half of 2006.

•Water, sewer, and trash collection rose at a 5 percent rate during those same six months.

•Hospital services spiked 8.5 percent.

•Shelter, one of the biggest household costs, rose at a 4.3 percent rate.

All that helps explain why the so-called core rate of consumer inflation, which excludes volatile food and energy prices, rose 0.3 percent for the third straight month in June.

It's a trendline that exceeds the Federal Reserve's comfort level. But it comes even as concern mounts that Fed policies – lifting interest rates 17 consecutive times since June 2004 to fight inflation – risk an economic slump. This could challenge the Fed, under new chairman Ben Bernanke, to walk a fine line between recession and an inflationary spiral.

"The problem of energy has made [the Fed's] job more difficult," thanks to a persistent upward trend in oil prices over the past two years, says Peter Kretzmer, a Bank of America economist in New York. The overall inflation rate, including energy, "has been running well above core inflation for 43 consecutive months."

Wednesday's news, and comments to Congress by Mr. Bernanke, hardly stirred panic on Wall Street (stocks and bonds rose during morning trading). But the question of inflation and possible recession won't be resolved soon.

In fact, economists say that core inflation could well rise in the months ahead even if Fed policy is successful.

"Regardless of what the Fed does at the next meeting and the next little while, probably inflation will remain a little bit elevated," Mr. Kretzmer says.

He expects the Fed policy will eventually work to slow the pace of inflation.

The problem for the economy and the Fed is that so far the inflation index hasn't been cooperating.

A panel of economists polled late last year predicted that the CPI would rise at a 2.2 percent annualized rate in the first quarter, and 2.4 percent in the second quarter. The actual rates have been 4.3 percent and 5.1 percent for those quarters, according to Wednesday's report.

Other indicators suggest that Fed moves are beginning to slow the economy.

Builders started fewer new homes in June, according to another economic report Wednesday. The real estate market is clearly cooling off nationwide, and US retail sales fell 0.1 percent in June.

But it is not certain that a slowing economy will lead to slower inflation.

"We think inflation is the key ... economic variable," David Malpass, an economist at the investment firm Bear Stearns in New York, wrote recently. "We expect core measures to rise more, but if it stays at current levels, it's a very good economic outcome."

Among the key factors that will determine inflation's course:

•Oil prices. Now at around $73 a barrel, they could keep rising if geopolitical tensions in places such as Iran, North Korea, and Lebanon worsen. The pocketbook impact: Motor-fuel costs in the CPI are up at a 52 percent annual rate for the year's first six months.

•Wages. Since labor is a much bigger cost for businesses than energy, a tightening of the labor market could push up wage pressures – and companies could pass those costs along to consumers.

•Expectations. If businesses and consumers believe prices will rise more, those expectations can become self-fulfilling and work against Fed policies. "The Federal Reserve," Bernanke said Wednesday, "must guard against the emergence of an inflationary psychology that could impart greater persistence to what would otherwise be a transitory increase in inflation."

•Globalization. In a more-global economy, price pressures are less subject to any one central bank's control.

"Anecdotal evidence, such as double- digit increases in labor costs in China for certain manufacturing workers ... points to diminishing economic slack," according to the recently released annual report of the Bank for International Settlements.

All this could complicate things on another front: the Fed's ongoing effort to maintain credibility as an inflation fighter.

Bernanke has had a rocky start, as some investors viewed early comments by him as "dovish" on inflation.

Even the Fed's reliance on the "core" rate of inflation could become problematic if overall prices keeps rising.

Fed policymakers often talk about the core rate as the key indicator of inflation. That can be useful, economists say. But Kretzmer notes that the overall inflation rate is what makes a dent in people's pocketbooks, and can drives expectations of future inflation.

Wednesday's report showed the CPI up 4.3 percent over the past 12 months. The core rate rose a notch faster than the overall rate for the month of June, and has risen 2.6 percent in the past 12 months.

It is widely believed that the Fed wants to keep the core rate below 2 percent.