Federal Reserve policymakers face one of their toughest decisions in years Tuesday when they must choose whether to hold interest rates steady amid signs of economic slowing or bump up rates yet again to fend off inflation.
In one of the most nail-biting times leading up to a Fed meeting in recent years, economists say it will be a close call when policymakers convene to examine rates and the state of the economy.
The Fed's goal is to slow the economy enough to prevent inflation from accelerating without crimping economic activity so much that it throws the economy into a recession.
With the economy and job creation losing momentum, some investors and economists believe the time is ripe for Fed Chairman Ben Bernanke and his colleagues to take a breather.
Investors are betting on a pause, but they are far from certain. On the futures market, chances of a rate increase Tuesday are put at only about 20 percent given recent evidence of a slowing economy. A Reuters poll of bond dealers Friday found that 17 of 22 think the Fed will hold rates steady.
Still, with core inflation above the Fed’s “comfort zone,” at least some policymakers are expected to argue for another rate increase to tamp down inflation risks.
Economists said the wording of the Fed’s statement would be crucial and would likely ncorporate some hawkish language to show it has not given up the fight on inflation.
“Beyond the coming meeting, we continue to judge that the markets are underestimating the risk of more rate hikes,” said Ethan Harris, chief U.S. economist at Lehman Bros. “'Pause’ does not mean 'finished.”’
The FOMC will announce its decision around 2:15 p.m. ET Tuesday.
The Fed, which has been lifting rates steadily since June 2004, now has 17 quarter-point increases under its belt.
Not all of those increases, though, have yet to be felt in the form of slower economic activity. It can take a year for a rate increase to work its way fully through the economy.
"The need to incorporate lags between policy actions and effects on the economy is a key issue," explained Janet Yellen, president of the Federal Reserve Bank of San Francisco. "So if we kept automatically raising rates until we saw inflation start to respond, we most likely would have gone too far."
Yellen is a voting member on the Fed committee that sets interest rates.
All told, the Fed's increases already have pushed borrowing costs to their highest level in more than five years.
The federal funds rate, the overnight rate that banks charge each other, stands at 5.25 percent. The funds rate influences other interest rates, including mortgage rates, and is the Fed's main tool for influencing economic activity.
Commercial banks' prime lending rate — for certain credit cards, home equity lines of credit and other loans — has moved up along with the funds rate and is currently 8.25 percent.
"I think the Fed will take a pause. The Fed wants to allow the economy to catch up with the rate increases that they have already ordered," said Lynn Reaser, chief economist at Bank of America's Investment Strategies Group.
Higher borrowing costs have played a role in curbing consumers' appetite to spend and cooling the once hot housing market, factors that have dampened overall economic activity. Cautious businesses, meanwhile, have tightened their belts and slowed hiring.
The nation's unemployment rate jumped to a five-month high of 4.8 percent in July, the government reported Friday. The weak employment report put new pressure on the Fed to take its foot off the economic brakes.
The economy's growth for the rest of the year is expected to continue at a subdued pace of 2.5 to 3 percent. In the April-June quarter, the economy clocked in at a 2.5 percent pace — less than half the brisk 5.6 percent growth seen in the prior three months.
Bernanke told Congress last month that slowing economic activity eventually should lessen inflation pressures. Nonetheless, Bernanke also said the Fed must stay on guard against the risk that lofty energy prices could spread inflation through the economy.
Other Fed watchers predict policymakers will bump up rates one more time Tuesday to blunt inflation.
Another quarter-point boost would hoist the funds rate to 5.5 percent and prompt commercial banks to raise their prime lending rates by a corresponding amount, to 8.5 percent. That could be the last rate increase for a while, economists in this camp said.
However, if the Fed does take a pass on Tuesday, economists said that probably will not spell an end to the central bank's credit-tightening. They believe another rate increase could be in store in September or later this year to keep inflation from taking off.
"Inflation risks still point upwards, and we suspect that the Fed will still have to hike again later in the year to combat inflation," said Nigel Gault, economist at Global Insight.
For the first six months of this year, consumer prices have risen at an annual rate of 4.7 percent. That's faster than the 3.4 percent increase registered in 2005.
The pickup in inflation this year reflects surging energy prices. Oil prices hit a new record closing high of $77.03 a barrel in the middle of July, and that record was threatened this week after the shutdown of an oil pipeline in Alaska. Gasoline prices also are at near-record levels of more than $3 a gallon in many areas.