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Fed waiting for clues on depth of slowdown

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When the inflation watchdogs at the Fed sat down Tuesday to review the cost of short-term borrowing, the outcome was a virtual replay of its last meeting in October. The central bank left interest rates unchanged and repeated a warning that inflation — not recession — remains the bigger threat.

After fears of rising prices prompted the Federal Reserve’s Open Market Committee to boost its benchmark rate from from 1 percent to the current  5.25 percent over two years ending in June, it’s now waiting to see whether it administered the right dose of economy-cooling medicine before making further changes.

Those rate increases did what they were supposed to do. But now with the U.S. economy clearly slowing, the big question is whether a cut in rates may be needed to revive growth.

Based on Tuesday's Fed statement and other recent comments by central bankers, by Fed members, inflation fears still have the upper hand in their discussions.

"Readings on core inflation have been elevated, and the high level of resource utilization has the potential to sustain inflation pressures," the Fed said in the statement, authored by Chairman Ben Bernanke and his colleagues. "However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand."

The Fed chairman’s economic crystal ball seems to be showing that the slowdown will ease next year, when growth will begin to pick up again — a view shared by many private economists. The risk is that Fed went too far with its rate hikes and the economy slides into recession.

But the latest economic data suggest that isn’t happening. Friday’s report that an estimated 132,000 new jobs were created in October reinforced the idea that the economy is still on a sound footing.

“I think we're slowing down, coming down for a soft landing,” said Stephen Gallagher, chief U.S. economist at Societe Generale. “At some point it either goes into further softening or accelerates. For the first part of 2007, we see that soft landing as the right story. Later in 2007, we'll be looking for some reacceleration in this economy.”

After kicking off the year with a sizzling 5.6 percent growth rate in the first quarter, the U.S. economy is now growing at less half that rate, due largely to a slowdown in the housing market and a slump in car sales. Economists have been steadily cutting their growth forecasts over the past few months; a poll of 54 of them conducted by the Blue Chip Economic Indicators newsletter found that the average forecast for the fourth quarter is now just below 2 percent. Some economists have been cautioning that — though the odds are still against it — the risk of recession is rising.

The hope is that the economic slowdown brings inflation down with it. A slump in sales of homes and cars has made it harder for sellers to raise prices, and a recent rise in inventories of manufactured goods should also help keep a lid on prices. A sharp drop in gasoline prices has also thrown cold water on inflation.

But Fed members fear that the level of so-called “core inflation” — which excludes food and energy prices — is running too high. (By excluding those two volatile commodities, the core rate is designed to spot longer-term price trends.)

"We have to be very careful that inflation doesn't stay at elevated levels for an extended period of time because if it does, it gets built into inflation expectations," Chicago Fed President Michael Moscow told CNBC Dec. 4.

Rising prices aren’t the only worry. With the unemployment rate at historic lows, some Fed members have voiced concern that tight labor markets might force employers to raise wages to attract and keep good workers. In last major outbreak of high inflation in the 1970s, a combination of rising wages and prices created a pernicious, long-term wage-price spiral.

Wages have been rising at a brisk pace recently. Some economists say that’s not a problem if worker productivity continues to increase. If a new technology, for example, allows a worker to produce more widgets, paying that worker more money doesn’t raise the cost of making each widget, so those higher wages aren’t passed through to the price of the widget.

“That old linkage between labor markets and inflation — that has pretty much gone the direction of the buggy whip in terms economic thinking,” said Brian Bethune, chief U.S. economist at Global Insight.

“Real wages for several years have lagged behind productivity. So workers are not being paid their productivity wage. So my question is — as soon as real wages start to go up, why would the Fed get all agitated about that?”

While the Fed calls the shots on short-term interest rates, the cost of long-term borrowing is set by the Treasury bond market — which has been unimpressed by the Fed officials’ public comments about keeping rates steady. A rally in Treasury bonds in the past few months has sent interest rates lower — a sign that bond traders expect the central bank early next year to cut the so-called federal funds that banks charge each other for short-term loans.

“I think the Treasury market believes that the U.S. economy is in for a possible hard landing in the event that Fed does not cut rates in early 2007,” said John Lonski, chief economist at Moody's Investors Service. “They have a different view about the ability of the U.S. economy to shoulder a 5.25 percent federal funds rate much longer."