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Next Fed action unclear after raising rates again

WASHINGTON—The Federal Reserve hiked its benchmark interest rate by another quarter-point to 3 percent on Tuesday and hinted that further rate increases may be needed to curb inflation even if they further slow the U.S. economy.

Tuesday's rate increase was the Fed's eighth consecutive quarter-point hike in the federal funds rate, which banks charge each other for overnight loans, since last June. Mortgage rates and consumer loans tend to rise and fall with the fed funds rate.

The Fed is at a fork in the road after 10 months of credit tightening: The rationale for raising rates further is balanced by the argument for pausing, an issue the Fed will have to address at the next meeting of its policy-making body, the Federal Open Market Committee, on June 29-30.

"There is no clear direction. We are not `obviously' going to continue in a tightening cycle, and we are not `obviously' at the end of one," said Stephen Wood, a portfolio strategist for the Russell Investment Group in Tacoma, Wash.

Fed Chairman Alan Greenspan and his fellow central bankers are struggling to check rising inflation without stalling a slowing economy. They're trying to get to a "neutral" zone, where credit policy neither stimulates nor slows the economy.

Their work is complicated by conflicting, even contradictory, trends.

High oil prices are sparking inflation throughout the economy, prompting the Fed to raise interest rates. Core inflation—not including volatile food and energy prices—continues to rise worrisomely, according to government measures of wholesale and retail prices, as well as the gross domestic product deflator, a broad inflation barometer the Fed favors. The trend argues for raising interest rates further to curtail borrowing and thus slow economic activity.

But other data indicate that economic activity already is slowing, and there are ample warnings that too much credit tightening by the Fed could trigger a recession.

Business spending is down sharply. Consumer spending drives two-thirds of all U.S. economic activity, but inventories are growing in warehouses and stockrooms, signaling consumer retrenchment. And first-quarter growth in the gross domestic product—the broadest measure of goods and services produced—slowed to a 3.1 percent annual pace. That was well below expectations, as the Fed acknowledged Tuesday.

"Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices," the Fed said in a statement.

Although job growth is improving, it said, inflation pressures "have picked up in recent months and pricing power is more evident."

Central bankers promised to continue pushing up rates "at a pace that is likely to be measured."

At the same time, the Fed hedged by issuing a follow-up statement two hours after its initial one, saying it had inadvertently omitted one sentence from its rate-hike announcement. The new statement added that "longer-term inflation expectations remain well contained."

That suggests that the Fed believes inflationary pressures are temporary.

Many analysts say the Fed now faces a conundrum.

"The slowing economy says stop raising interest rates, while rising inflation says to continue raising them," said John Makin, an economist at the American Enterprise Institute, a neoconservative Washington policy organization.

The Fed could go either way at its June meeting.

"The balance of risks right now is that inflation is more modest than some of the fears out there," said Wood.

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(c) 2005, Knight Ridder/Tribune Information Services.

GRAPHIC (from KRT Graphics, 202-383-6064): Interest rates

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