US Fed's inflation concerns likely to limit rate cut

Federal Reserve officials are being forced to consider limiting the size of future interest rate cuts because of the worsening inflation picture.

That suggests that when the Federal Open Market Committee meets on March 18 it will reduce its 3 per cent overnight lending rate target by a half points and some officials may be arguing only for a quarter point.

For the first time in decades, the central bank "� whose dual mandate is to achieve both stable prices and maximum sustainable employment "� is facing a serious policy dilemma: Doing what's needed to achieve one goal may put another one further out of reach.

The recent reports that payroll employment fell in both January and February at the same time that oil prices hit a record of more than $106 a barrel only highlighted the problem.

"It is this unpleasant combination of risks to both inflation and employment that the FOMC must balance as it assesses the appropriate path for monetary policy,'' Janet L Yellen, president of the San Francisco Federal Reserve Bank, said at a conference in Paris on March 7.

That balancing suggests it's unlikely that the Fed will cut by three-quarters of a percentage point, which investors thought was a 98 per cent probability according to Fed funds futures contracts on March 7.

Mistaken impression
The concern is that slashing the lending-rate target might give the public the mistaken impression that the Fed will pull out stops to head off a possible recession "� regardless of the outlook for inflation.

This is also a consideration weighing against cutting rates prior to next week's meeting, a step a number of analysts have been predicting. On January 22, the FOMC surprised the market by cutting the target by 75 basis points only eight days before a scheduled committee meeting and then trimmed it by another 50 basis points at the meeting.

That swift set of actions in January "shouldn't lead markets to expectations that we will continue to react in that manner,'' Richard Fisher, Yellen's counterpart at the Dallas Fed cautioned in a March 7 interview in Paris.

What's at stake is the Fed's credibility as a central bank intent on keeping inflation low. And far more than just its reputation is involved.

"It is the credibility of monetary policy that, in my view, has helped to ensure that the inflation shocks resulting from energy, food, materials, and exchange rates do not spill over into inflation expectations and wage setting,'' Yellen said in Paris.

Inflation expectations
As many of her FOMC colleagues have said in recent public appearances, Yellen expects inflation to moderate over the next couple of years. However, she acknowledged, that prediction assumes that energy and food prices will stabilize "near current levels,'' and that expectations of future inflation don't rise.

Generally, Fed chairman Ben S Bernanke, and most of his colleagues have said regularly that inflation expectations appear to be "well anchored,'' or words to that effect.