By Steve Matthews
June 25 (Bloomberg) -- The Federal Reserve may signal today that inflation is starting to replace a recession and the credit crunch as the biggest risk facing the economy.
Chairman Ben S. Bernanke and his colleagues are laying the groundwork for a policy shift after oil prices doubled in the past year and inflation exceeded 4 percent. At the same time, they may be reluctant to go too far because the economy has yet to shake off the credit crunch and bank losses are deepening.
The Federal Open Market Committee will leave the benchmark interest rate at 2 percent today, ending the fastest series of reductions in two decades, according to all 102 economists surveyed by Bloomberg News.
``They are going to lean a bit more to inflation risks than growth risks, and may provide a hint they could hike rates down the road,'' said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc. in New York. ``They will signal their concern in a subtle way, not explicitly. They don't want to have a statement that would tie their hands.''
Today's statement is scheduled for about 2:15 p.m. in Washington. Officials may say their past actions are helping sustain growth, while price increases might take time to moderate, Fed watchers said.
Fed governors and district-bank presidents are bringing new quarterly forecasts to the meeting, which began yesterday in Washington. As recently as April, ``many'' of them foresaw an economic contraction in the first half. That's now unlikely after more than $70 billion of tax rebates helped keep Americans spending and record exports eased the slump in manufacturing.
Bernanke's Assessment
Bernanke in a June 9 speech said that risks of a ``substantial downturn'' in the economy had diminished. He also flagged concerns about consumer prices, and warned that the Fed will ``strongly resist'' a leap in inflation expectations.
In the statement after their April 29-30 meeting, policy makers predicted inflation would ``moderate in coming quarters'' with a ``leveling out'' of commodity prices. Since then, gasoline prices have surged 13 percent to a record, and consumer expectations for average inflation over the next five years reached the highest since 1995.
Bernanke's warning this month spurred traders to bet on a rate rise. There are 33 percent odds of a boost in August and 88 percent in September, according to contracts quoted on the Chicago Board of Trade.
Emergency Measures
One impediment to an early increase may be the Fed's emergency programs providing funds for investment banks. Officials introduced them in March to alleviate the credit crisis that pushed Bear Stearns Cos. close to bankruptcy.
It may be difficult for the Fed to justify raising the cost of credit while at the same time lending to nonbanks, something it's only supposed to do under ``unusual and exigent circumstances'' when no other ``adequate'' credit is available.
The Primary Dealer Credit Facility allows securities firms to borrow from the Fed overnight at the same so-called discount rate available to commercial banks. The Fed said in March the program would be in place ``for at least six months.''
``The withdrawing of facilities creates some risk'' for the credit-market outlook, said Brian Sack, senior economist at Macroeconomic Advisers LLC in Washington and a former research manager at the Fed board. ``They may want to withdraw the facilities and see how credit conditions respond before'' lifting rates, he said.
Policy Priority
In its April 30 statement, the FOMC avoided specifying whether weaker growth or faster inflation was the greater concern. In their paragraph telegraphing policy priorities, officials may reiterate they will ``act as needed'' to promote both economic expansion and stable prices, Fed watchers said.
That would afford policy makers some flexibility. Higher borrowing costs now would hurt banks grappling with mounting losses. Commercial bank loans written off as unrecoverable climbed to 0.97 percent of the total in the first quarter, the highest since 2002, Fed data showed last month.
``It's a delicate balancing act -- don't look for a signal of a strong inclination for raising rates,'' said Michael Feroli, a former Fed researcher who is now an economist at JPMorgan Chase & Co. in New York.
One way of strengthening the message on inflation would be to echo the emphasis that Bernanke, Vice Chairman Donald Kohn and other officials have placed this month on keeping inflation expectations in check. In its last statement, the FOMC said it was important to monitor price developments ``carefully.''
Inflation Expectations
American consumers foresee average annual inflation of 3.4 percent over the next five years, the highest expectation since 1995, according to a Reuters/University of Michigan survey. The five-year outlook among investors has been more stable, at 2.41 percent, up from 2.31 percent in January, according to a measure derived from inflation-linked Treasuries.
Consumer prices rose 4.2 percent in the 12 months to May, government figures show.
``They might emphasize their concern with inflation expectations, saying that it will be necessary to continue to monitor inflation developments, and particularly inflation expectations, carefully,'' said former Fed governor Lyle Gramley, who is now senior economic adviser Washington for Stanford Group Co., a wealth-management firm.
To contact the reporter on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net.
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