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    =WSJ: Fed Leaves Rates Steady, Gambling On Econ Slowdown(DJ)

 
   By Greg Ip
   Of THE WALL STREET JOURNAL
 
  WASHINGTON (Dow Jones)--The Federal Reserve left interest rates
steady on Tuesday for the first time in two years, gambling that a
nascent economic slowdown will cap growing inflation pressures.
  In leaving its short-term interest rate target at 5.25%, the Fed
said: "Readings on core inflation have been elevated in recent
months," but "inflation pressures seem likely to moderate over
time, reflecting contained inflation expectations and the
cumulative effects of monetary policy actions and other factors."
  (This story and related background material will be available on
The Wall Street Journal's Web site, WSJ.com)
  For the first time since Ben Bernanke took over as chairman on
Feb. 1 from Alan Greenspan, the policy-setting Federal Open Market
Committee did not agree to the action unanimously. Federal Reserve
Bank of Richmond president Jeffrey Lacker dissented, favoring
instead another quarter-point increase.
  The statement said, as it did after the last meeting in June,
"Some inflation risks remain. The extent and timing of any
additional (increases) ... to address these risks will depend on
the evolution of the outlook for both inflation and economic
growth." The retention of that sentence, in effect, reflects a
continued bias, but not a presumption, to raise rates in the
future. The Fed effectively gave itself some breathing room to
assess the impact of the preceding 17 quarter-point rate increases
before deciding whether to hike again. Bernanke has been suggesting
since April that he was seeking more flexibility.
  "A pause does not mean a stop," said Stephen Stanley, chief
economist at RBS Greenwich Capital Markets. "And there's certainly
ample evidence the economy has been on a slowing trajectory over the
last couple months. There's enough evidence there for them to take
six weeks off."
  Signs of slowing growth and rising inflation have aroused deep
disagreements among economists on what the Fed should do. Some
economists think the Fed has already raised rates too far and is
courting recession; some think it must raise them further to stop
inflation from accelerating.
  Some say both things are true. "You can't fight inflation without
risking overkill on the economy," said Ethan Harris, chief U.S.
economist at Lehman Brothers, who thinks the Fed shouldn't have
paused and predicts it will eventually raise the rate to 5.75%.
"That is a risk, and it's a risk they should take." He added:
"It's not fair to Bernanke that he steps into his job just as the
economy is set to decelerate and inflation takes off."
  The Fed's view has been that inflation recently topped the
informal "comfort zone" of 1% to 2%, excluding food and energy,
primarily because firms have passed higher energy costs on to
consumers. If growth does not exceed "potential" -  the rate at
which the economy can grow without straining the available
workforce and capital stock - and energy prices stabilize, the Fed
figures inflation should drop back. Meanwhile, it believes that as
the housing market cools and consumer spending slows, business
investment and exports will pick up the slack.
  But recent data have not been supportive of that view. Economic
growth slowed to 2.5% annual rate in the second quarter, in part
because of a surprise drop in business equipment investment.
Macroeconomic Advisers, a forecasting firm, predicts it will grow
at about the same moderate rate in the current quarter. Payroll
growth was sluggish, and the unemployment rate rose in July.
  But at the same time, inflation has ticked higher, and new data on
productivity, growth and labor costs suggest that inflation
pressures have been bubbling longer than previously realized.
  The Labor Department said Tuesday nonfarm business productivity
grew at a 1.1% annual rate in the first quarter, a sharp decline
from the 4.3% growth rate of the first quarter, and was up 2.4%
from a year earlier. At the same time, labor costs per unit of
output climbed 4.2% in the second quarter and were up 3.2% from a
year earlier. Labor costs were actually declining in 2004, but
have steadily accelerated since, and now are rising fast enough to
eat into profit margins - which could encourage firms to try harder
to raise prices. Importantly, Tuesday's Fed statement did not
repeat a reference from June's that "ongoing productivity gains
have held down the rise in unit labor costs".
  Revisions to economic data from 2003 to 2005 also show the economy
grew less quickly and inflation was a bit higher than previously
thought. That, economists say, suggests the economy's "potential"
growth rate is lower than previously realized, and the economy may
already be straining capacity.
  None of this means the Fed is making a mistake now. Indeed,
inflation and labor costs were both rising in 2000 when it last
stopped raising rates after a cycle of increases. In retrospect,
however, the downturn in tech stocks and subsequent decline in
tech investment had already set in motion a slide into recession
the following year and a big drop in inflation. There are concerns
that an accelerating downturn in the housing market today could
similarly undermine the overall economy now.
  "There was a strong case for pausing at 4.5%," said Ian
Shepherdson, chief U.S. economist at High Frequency Economics.
"There was already plenty of evidence the previous hikes had begun
to soften growth." He predicts the Fed will start to cut rates by
next April.
  Nouriel Roubini, an economist at New York University and author of
a popular economics blog, said it's already too late to prevent a
recession. "The Fed should have tightened earlier to avoid a
festering of the housing bubble early on. The Fed is facing a
nightmare now: the recession will come and easing will not prevent
it."
  Lakshman Achuthan, managing director at the New York-based
Economic Cycle Research Institute, said the economy is not now
headed into recession, but it is slowing and thus more vulnerable
to some kind of shock that tips it into one. At the same time, he
said, inflation shows no sign of turning down soon. So, "The Fed
may have to stay in the game, even though there are elements
slowing the economy that still have to play out."
 
  -By Greg Ip, The Wall Street Journal
 
  (END) Dow Jones Newswires
 
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