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As economy strengthens, hopes fade for rate cut

With both businesses and consumers in a spending mood, the economy bouncing back, and inflation apparently in check, hopes for a cut in interest rates by the Federal Reserve have all but vanished.  By’s John W. Schoen.

Just a few months ago, former Fed chief Alan Greenspan was musing out loud about the odds of a U.S. recession. Economists and investors were debating how soon the central bank would cut short-term interest rates to help ease the impact of a widening housing slump.

But with both businesses and consumers in a spending mood, the economy bouncing back, and inflation apparently in check, those hopes for a rate cut have all but vanished.

As a result, long-term interest rates, which are set on the open market, have surged, sending the average 30-year mortgage to 6.74 percent, up from 6.15 percent just six weeks ago.

The latest good news for the Federal Reserve came with this week’s reports on producer and consumer prices showing inflation largely in check. The data helped ease fears that a rebounding economy could rekindle inflation.

One of biggest economic concerns lately has been that rising energy prices could spill over into the cost of other goods. High gasoline prices already have put pressure on consumers’ pocketbooks.

But while pump prices have attracted a lot of attention, they make up only a small piece of overall consumer spending. Gas price increases have been partly offset by falling prices for other goods and services.

“People remember what they buy frequently. They have a less consciousness of what they buy infrequently,” said Kevin Logan, an economist with Dresdner Kleinwort Wasserstein. “That's where the downward pressure on prices is. It is mostly cars, computers, consumer commodities, electronics — these sorts of things.”

So while a 50-cent increase in a gallon of gasoline can add up to a few hundred dollars in higher cost for consumers, they may more than make up for that by waiting for big price cuts before they buy that big-screen TV.

In any case, higher energy prices haven’t seriously cut into spending by consumers or businesses. Retail sales in May were stronger than many economists had expected, the government reported last week.

And after a big drawdown in inventories and weak investment in new equipment in the first quarter, when the economy inched ahead at a sluggish 0.6 percent rate, businesses have bounced back, filling orders to restock shelves. They’re also in a hiring mood, quickening the pace of hiring and creating a net gain of 157,000 new jobs in May.

As a result, in just the past few weeks the outlook in interest rates did an about-face — from expectations that the Fed might have to cut rates by the end of the year to give the economy a boost to a widely held belief that the central bank will likely do nothing. That view was all but confirmed, in a 20 words or less, by Fed Chairman Ben Bernanke this month.

"Although core inflation seems likely to moderate gradually over time, the risks to this forecast remain to the upside," he said in a June 5 speech.

Those comments were seconded by Chicago Fed President Michael Moskow, who said last week that the job market's surprising strength means the biggest risk is still that inflation will not fall as expected. Though it has no official target, it's widely believed that the Fed is looking to keep inflation in a range of between 1 and 2 percent.

As a result, some observers now believe the Fed's next move may be to raise rates. The prevailing view seems to be that as long as the economy remains in the current sweet spot — relatively good growth and tame inflation — the central bank is happy to leave well enough alone. A poll of 115 economists this week by Reuters found that the median forecast calls for the Fed to hold rates steady through the end of this year and all of 2008.

The bond market — which governs long-term rates — now seems to agree with the outlook for Fed policy on short term rates. The wind shifted abruptly this week as the yield on 10-month Treasury bonds shot up by nearly a quarter of a point to 5.25 percent.

“I think what it's reflecting is a shift in market sentiment from believing that the next Fed move would be down to instead saying ‘I just don't know,’ said UBS chief economist Maury Harris.