Will Fed begin to raise rates soon?

The Federal Reserve is expected to signal whether inflation is its top concern.

Since last September, the Federal Reserve has cut interest rates 3-1/4 percentage points – a drop at each Fed meeting, plus some emergency reductions coming in the middle of the credit crisis.

This month, for the first time in 10 months, interest rates appear unlikely to change.

As Ben Bernanke convenes a Federal Reserve meeting Wednesday, Fed watchers will be looking for language that warns investors to get ready for a rate rise as early as August. If the Fed does signal it's preparing to hike short-term interest rates, it would indicate the central bank is now more concerned about inflation than the faltering economy.

The Fed's potential actions could have widespread effects aside from raising the cost of short-term borrowing by a small amount. The dollar, which has been pounded, could firm up. A stronger dollar might help pull some of the speculative money out of the oil market.

"If the Fed were to raise rates, it would have important implications for the dollar, for oil, for market psychology and interest rates," says Lyle Gramley, a former Fed governor and now a consulting economist at the Stanford Group in Washington. "But I think the reason they are reluctant to raise rates is that we still have a fragile economy."

Ahead of the meeting, the financial futures markets predicted a 60 percent probability that the Fed would raise rates in August. Earlier this month, the financial markets were far more certain: They gave an 80 percent probability of a rate hike.

"Signals were sent by Fed officials that they are not as eager to raise rates as the markets expected," Mr. Gramley says. "This is a very difficult situation for the Fed because if inflation gets out of hand, you pay a dear price to get it back down again."

Inflation, as measured by the Consumer Price Index, has been running at about 4 percent annually. However, the Fed often focuses on the "core CPI," which excludes food and energy. It has been rising at about 2.5 percent annually.

"Everyone in the universe questions the core CPI numbers," says Fred Dickson, chief market strategist at D.A. Davidson in Lake Oswego, Ore. "We see signs across the board that price increases are making their way into our lives, whether it's in the form of extra delivery charges or shrinking product sizes."

Because of the inflation concern, some Fed observers expect the Fed to include a stronger inflation warning in its statement. The statement can be a form of jawboning, or moral suasion, Mr. Dickson says. "They will let the capital markets act as a result of the jawboning since the Fed is basically hamstrung."

Longer-term rates have already increased. In the past several weeks, 10-year Treasury notes have moved up half a percentage point. Mortgage rates have mirrored the rise.

"For the Fed, this is the biggest risk factor – a further deterioration of home prices if people pull back from buying because mortgage rates are rising," Dickson says.

On Tuesday, according to a new Standard & Poor's/Case-Shiller report, home prices continued "steep declines" in April, losing 1.4 percent from March. Since the beginning of the year, home prices are down 15.3 percent. "There might be some regional pockets of improvement, but on an annual basis the overall numbers continue to decline," said David Blitzer, chairman of the Index Committee at S&P in New York, in a statement.

Some Fed experts say that Mr. Bernanke has time to assess upcoming economic data before he needs to move. For example, the June unemployment rate and weekly unemployment claims will both be released July 3. In May, the unemployment rate popped up to 5.5 percent from 5 percent.

Bernanke will be watching the new jobs information carefully, says Fed expert Doug Roberts of Channel Capital Research in Shrewsbury, N.J.

"The last couple of Fed moves revolved around bad unemployment numbers," says Mr. Roberts, author of the book "Follow the Fed to Investment Success." "Unemployment is a big thing, especially for election years."

Roberts believes the Fed is concerned that a further bump up in unemployment could exacerbate the housing decline. "As long as you are employed, you are less likely to abandon your house and move into an apartment. But if you are unemployed and see no possibility of a job, you may decide to leave the keys on the table," he says. "That's one of the reasons I think the Fed will tolerate inflation versus unemployment."

The Fed may also have some slack because there are few signs of labor asking for large pay increases. "The last I knew, wages accounted for 60 percent of the cost of goods sold, and there has been no acceleration in wages whatsoever," argues Robert MacIntosh, chief economist at Eaton Vance in Boston.

If the Fed were to shift to a more European approach to inflation – that is, considering energy and food in the inflation rate – an interest-rate rise would be a greater probability, Mr. MacIntosh says.