By John W. Schoen Senior producer
updated 5/9/2007 7:12:57 PM ET 2007-05-09T23:12:57

As expected, the Fed left short-term interest rates just where they are at its regular meeting of the Federal Open Market Committee Tuesday. Thanks to a weak dollar, slowing job growth, a slow but growing economy and money pouring in from around the world, the rate-setting gang is happy to sit back and let these forces do their inflation-fighting for them.

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The decision — the seventh straight time the Fed has kept rates steady — had been widely expected by financial markets. The closely-watched written statement that accompanied the meeting held few clues about the Fed’s next move. It noted that “economic growth slowed in the first part of this year” — last time it said economic indicators were “mixed.” But the statement noted that inflation — which higher rates keep in check — was still running a little stronger than it should be. Echoing recent public statements by Fed members, the statement said a main concern was “the risk that inflation will fail to moderate as expected.”

There are plenty of reasons the Fed’s “steady-as-she-goes” policy could change. So far, the ongoing housing slump doesn’t seem to have dragged the overall economy down with it. A wider slump could force the Fed’s hand, bringing a rate cut to help get the economy back on track.

“That’s the kind of thing that might at some point down the road trigger a Fed easing, but that’s not something that I think they’re looking for now,” said Alfred Broaddus, former president of the Richmond Fed.

Lately, the U.S. economy has been getting some help from an unusual source — the weak U.S. dollar. That has helped make U.S. products cheaper in overseas markets.

“Exports are definitely growing; it’s a product of the weaker dollar,” said John Manley, a stock market strategist at Smith Barney. “We don’t see that reversing itself.”

Those higher exports have helped U.S. companies keep growing without the benefit of a rate cut from the Fed. Despite concerns that the slumping U.S. economy would take a bite out of U.S. corporate earnings, companies that have expanded into overseas markets have been bringing home bigger profits — especially after they convert relatively strong currencies like the euro or yen back into weaker U.S. dollars.

“The offset (of a slower U.S. economy) from the very strong reports that we’re seeing overseas is very important,” said Jeremy Zirin, a market strategist with UBS Wealth Management. “We saw that in the first-quarter earnings, where companies that were more exposed to the foreign markets, their earnings grew 13 percent, and companies more exposed to the domestic market only grew earnings 4 percent. So I think that mitigates the risk of U.S. consumer-led slowdown.”

The weak dollar, though, could eventually force long-term interest rates higher. That’s because over the long term, a falling U.S. currency makes it harder for the U.S. Treasury to sell dollar-denominated bonds to overseas investors who lose money if the dollar falls further.

For now, though, the large flow of capital coming into the United States — much of it from foreign investors buying those Treasury bonds — is helping the Fed do its job. But there’s no guarantee that will go on forever, as Fed Chairman Bernanke pointed out last week.

“Real interest rates, despite the fact that there are issues of budget deficits and so on ... remain very, very low, and that's the force of the savings that are coming into the country, pushing down real interest rates,” Bernanke said in a speech in Montana. “We won't always have that, and that's why it's important for us to work on increasing our own savings rate.”

Still, as long as the economy dodges a recession, the Fed seems to think that inflation remains Public Enemy No. 1, judging from public statements made since the last FOMC meeting in March.

So far, so-called “core” inflation — which excludes volatile food and energy prices — is just a tad outside the Fed's 1 percent to 2 percent “comfort zone.” But one reason the panel may be worried about a pickup in inflation is the slowing in the growth of worker productivity in the U.S., according to Broaddus.

“That would tend to make the longer-term inflation outlook maybe a little bit less favorable than would otherwise be the case,” he said. “And I think that might be in the minds of some members of the committee.”

Even as the Fed worries aloud about inflation, the slowing economy has helped the central bankers stick to their “do-nothing” strategy.

That’s in part because inflation gets some of its momentum from rising wages, which usually accompany tight labor markets. When it’s hard to find skilled workers to fill jobs, employers have to pay more to find them — and keep them from looking for better-paying work elsewhere.

These days, despite the slowdown in productivity, the Fed seems to be getting some help on the labor front. Last week’s employment numbers showed a continued slowdown in job growth in April, and a slight uptick in the unemployment rate. And the latest report on gross domestic product — showing the economy moving ahead just 1.3 percent in the first quarter — also included data showing wages are growing more slowly.

“(The GDP report) is ideal from the Fed's perspective of keeping policy on hold, despite concerns that inflation may not moderate,” said John Ryding, chief economist at Bear Stearns. “The report is consistent with moderate economic growth and a slight easing in labor market pressures.” 

And with the rising stock market continuing to attract investment, the Fed doesn’t seem to be worried that there’s not enough money sloshing through the financial system.

“I think their idea going through the whole year will basically be: Let the market do the work,” said Bill Buechler, a money manager at Barclay Partners Asset Management. “There will be times when people are looking for a rate cut and times for a rate hike, but in the end I think they're going through the entire year of doing nothing and staying status quo."

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