Fed facing a new problem

WASHINGTON — WASHINGTON -- The Federal Reserve, for all its power, faces tough new limits on its ability to keep the economy out of a recession.

Even though the Fed slashed short-term interest rates twice in January, home mortgage rates have edged up steadily in the past few weeks and credit for businesses is as tight as it was when financial markets seized up in August.


Yesterday, the central bank, led by Ben S. Bernanke, found itself facing hints of a problem the United States has not seen in decades: stagflation, the mix of slumping growth, sharp spikes in oil and food prices and a rising pace of overall inflation.

The Labor Department reported that consumer prices jumped 4.3 percent in January, compared to one year earlier. That was the biggest jump in more than two years. Even after excluding the volatile prices for food and energy, inflation was up 2.5 percent - well above the central bank's unofficial target of 1 percent to 2 percent.


A few hours after the report on consumer prices, Fed officials acknowledged that they had reduced their forecast for growth this year to an anemic pace of 1.3 percent to 2 percent and that joblessness is likely to climb to 5.3 percent from 4.9 percent today.

The Fed's new forecast assumes that growth will be all but stagnant for the first six months of this year before the economy gets a lift in the second half from the economic stimulus package Congress recently passed, as well as from the Fed's decisions to sharply lower interest rates.

To be sure, inflation is nowhere near the double-digit rates of the late 1970s, and many economists agree with Fed officials that inflation will cool as the economy slows.

But the combination of rising prices and stalling growth, aggravated by the deepening downturn in housing and credit markets, has put the Federal Reserve in a box of its own making.

On one hand, officials are cutting interest rates to keep the economy growing at a time when oil prices are surging, credit is tightening and major financial institutions are shell-shocked from the housing and mortgage busts.

On the other, the fear of rising inflation makes it more difficult for the Fed to jolt the economy with another wave of cheap money. Lower interest rates have pushed down the value of the dollar, which in turn prompted oil-producing countries to push for higher oil prices.

"They are walking a very fine line right now," said Stephen Cechetti, a professor at Brandeis International Business School. "They are trying to maintain their low-inflation credibility at the same time they are dramatically cutting interest rates. The facts are that growth is falling quickly, and that inflation is high and rising."

Fed officials do not see themselves as powerless. The central bank stunned investors by slashing rates twice in January. Those move brought the Fed's benchmark overnight lending rate down to just 3 percent.


According to minutes of the Fed's two January meetings, released yesterday along with policymakers' latest economic projections, officials were increasingly worried that plunging confidence in financial markets would lead to a self-fulfilling prophecy of tighter credit conditions, stalling activity in the real economy and even more fear in financial markets.

But at least some Fed policymakers were also worried about rising inflation. William Poole, president of the St. Louis Fed, dissented from the first rate cut Jan. 21 and Richard Fisher, president of the Fed's Dallas branch, dissented from the second one Jan. 30.

The new Fed forecast, a compilation of the individual projections by Fed governors and the presidents of the regional Fed banks, anticipates that inflation will slow in response to slower economic growth and that consumer prices will rise between 2.1 percent and 2.4 percent this year.

Fed policymakers made it clear they were willing to reduce interest rates to prevent a serious downturn, even if inflation was slightly higher than they wanted, according to the minutes.

In a nod to the more aggressive inflation-fighting members on the Fed's policymaking committee, the minutes also noted that policymakers should be ready to reverse course rapidly if the prospects for growth improve.

"All this sets the stage for a difficult dilemma for the Fed," Bernard Baumohl, managing director of the Economic Outlook Group, a forecasting firm in Princeton, N.J., wrote in a report to clients. "The only sure way the central bank can keep inflation expectations subdued is to tighten monetary policy and raise interest rates until investors, employees and business leaders are convinced that prices will remain low and stable."


But Baumohl predicted that inflation will indeed moderate as Fed officials hope, noting that major discount retailers such as Wal-Mart have slashed prices in anticipation of lower consumer spending.