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Key to Fed action may be how high energy prices go

WASHINGTON—The Federal Reserve is expected to raise short-term interest rates Tuesday for the 10th consecutive time, raising questions of when this 15-month cycle of hikes will draw to a close.

Most analysts agree that the Fed is all but certain to raise its benchmark federal funds rate, which banks charge each other for overnight loans, by the usual quarter-percentage point to 3.5 percent. That drives up many consumer bank-loan rates, including the prime rate.

The Fed has been nudging up short-term rates since June 2004 in an effort to keep a lid on inflation—the pace of rising prices—which erodes consumers' purchasing power. As rates rise, they make borrowing more expensive, which discourages people from some purchases. That slows economic activity, thus taking the steam out of price inflation.

Whether further rate hikes will be necessary may depend on the price trend for crude oil and other fuels and how those prices are passed through to industry and consumers. The Fed's mission is to find a neutral zone for lending rates that promotes economic growth but doesn't overheat the economy and trigger inflation.

Fed Chairman Alan Greenspan told Congress last month that inflation is contained for now, but lurks as a threat.

Crude oil prices are setting new records almost daily—approaching $64 a barrel Monday—although after adjusting for inflation, oil prices were higher in the early `80s.

"A further rise (in energy prices) could cut materially into private spending and thus damp the rate of economic expansion," Greenspan told the Senate Banking Committee on July 20.

So far that hasn't happened much. The U.S. economy grew at a 3.8 percent annual rate in the first quarter of this year and a 3.4 percent annual rate in the second quarter.

"The economy is doing quite nicely, so we expect the Fed to continue to tighten," said Augustine Faucher, a senior economist at Economy.com, a consulting firm in West Chester, Pa. He forecasts Fed rate hikes through 2006, though at a slower pace, ending next year at 4.75 percent.

"The biggest wild card remains energy prices," Faucher said. "If oil remains near $60 per barrel, that could lead to broader inflation, while at the same time weighing on economic growth. This would present the Fed with a major dilemma."

Those who think the Fed will continue raising rates point to Greenspan's favorite inflation gauge, called the Core Personal Consumption Price Deflator. It measures the average increase in prices for all domestic personal consumption, the largest component of the gross domestic product—the sum of a nation's goods and services. From June 2004 to June 2005, the measure rose by 1.9 percent.

When the gauge exceeds a 2 percent annual rate, it raises fears that inflation is breaking loose. However, the April-June quarter's numbers were less ominous, at 1.4 percent.

"The deflator has moderated in recent months, so should the rates keep going up or not?" asked John Silvia, chief economist for Wachovia, the banking giant in Charlotte, N.C. He expects more Fed rate hikes in September and November, but said the outlook beyond that was anybody's guess.

James W. Paulsen, chief investment strategist for Wells Capital Management, part of San Francisco-based Wells Fargo Bank, is more worried about rising commodity prices for goods such as copper and aluminum than about oil. He thinks the question for the Fed is whether the world economy is heating up or slowing down.

"Economic growth has proved far stronger and broader globally than most expected, (corporate) profits have been much stronger and the consumer has been remarkably resilient. The Fed, based on these facts, will bias the discussion toward continued tightening," Paulsen said.

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

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