Federal Reserve Largely Seen Pausing Rate Hikes, But Uncertainty Remains

Federal Reserve policymakers sit down on Tuesday for what might be one of their most difficult interest rate decisions in years.

Financial markets are confident that the Federal Open Market Committee will opt to keep the benchmark federal funds rate at 5.25 percent, pausing a string of 17 increases stretching back to June 2004.

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In the futures market, chances of a rate increase are near 20 percent, given recent evidence of a slowing economy. A Reuters poll of primary bond dealers on 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 incorporate 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 Brothers. "'Pause' does not mean 'finished."'

The FOMC will announce its decision around 2:15 p.m. EDT on Tuesday.

So, what will policymakers be considering at the meeting?


* U.S. employment growth has trailed off. July payrolls growth was 113,000, the fourth straight month under 125,000 after averaging 176,000 a month in the first quarter. The July jobless rate rose unexpectedly. Still, average hourly earnings continue to climb, maintaining concerns about wage inflation.

* The Fed's preferred measure of inflation, the core personal consumption expenditures prices index, rose a moderate 0.2 percent in June but the year-on-year rate hit nearly a four-year high of 2.4 percent, well above the Fed's perceived comfort zone.

* Oil prices are higher since the June FOMC meeting and are now over $76 a barrel. High gasoline prices have put pressure on households by cutting into discretionary funds available for other spending -- but at the same time threaten to keep leaking into core inflation.

* Some retailers reported weaker-than-expected sales in July; the overall climate was termed lackluster. The government's official retail sales report for July is due on Friday, days after the Fed meeting.

* Second-quarter U.S. economic growth slowed to 2.5 percent from the first quarter's cracking 5.6 percent pace. Both the Fed and private economists look for a further slowing in the second half of 2006.

* The U.S. housing sector continues to lose momentum. Sales of existing homes in June posted their slowest pace since January and new single-family home sales fell 3 percent. Major home-building companies have reported lower orders and cut profit forecasts.

* The U.S. services sector, which accounts for around 80 percent of economic activity, was weaker in July. The Institute for Supply Management's services index fell to 54.8 from 57.0. Still, factories are "hanging in" despite persistently high input prices. ISM's manufacturing index rose in July to 54.7 from 53.8.


* Minutes from the Fed's June meeting showed officials were uncertain about what their next steps should be. Many FOMC members have stayed underground since June, a move interpreted by some Fed-watchers as symptomatic of the tough decisions that lie ahead.

* Federal Reserve Chairman Ben Bernanke told Congress in July that the Fed believed the economy was "in a period of transition" to more moderate growth in line with its non-inflationary potential. His remarks were a key element in quashing expectations of an August rate hike.

* Janet Yellen, San Francisco Fed president and an FOMC voting member in 2006, last week pressed the issue of the gap between Fed policy moves and their economic impact. Yellen in theory endorsed the idea of pausing the rate-hike cycle before inflation turns lower.

* St. Louis Fed President William Poole handicapped chances for Tuesday's meeting at more like 50/50 based on the blend of slowing growth and niggling inflation and cautioned against a "more draconian policy" than might be necessary.

* Thomas Hoenig, Kansas City Fed president, termed the current fed funds rate of 5.25 percent "slightly restrictive" and warned of a risk the Fed could overshoot on rate hikes.

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