By Scott Lanman
June 26 (Bloomberg) -- The Federal Reserve is sounding the alarm on inflation without committing to raise interest rates.
The Federal Open Market Committee left its benchmark rate at 2 percent yesterday and said ``upside risks'' to prices have picked up. The statement also said consumer spending is ``firming,'' while acknowledging that rising energy prices will curb growth into 2009.
The FOMC cited ``the elevated state'' of some measures of inflation expectations and dropped an April forecast of a ``leveling out'' in commodity prices. The officials want to keep their options open on rate changes in case the credit crisis worsens and the economy deteriorates after consumers spend their tax rebates, Fed watchers said.
``It is a baby step in the direction of raising rates,'' said Stephen Stanley, chief economist at RBS Greenwich Capital Markets in Greenwich, Connecticut. The central bankers signaled ``they are not expecting to tighten in the near term. That is as far as they are willing to go,'' he said.
Two-year Treasury yields, more sensitive to Fed rate expectations than longer-dated debt, initially rose after the central bank's announcement, before dropping later. The notes yielded 2.78 percent at 8:08 a.m. in New York, from 2.81 percent late yesterday.
The FOMC said employment had weakened and financial markets remained under ``considerable stress,'' even as growth risks ``diminished somewhat.''
Pledge to Act
Chairman Ben S. Bernanke and his colleagues stopped short of specifying that inflation was a greater concern than growth. They reiterated language from their April meeting that the Fed will ``act as needed'' to promote both economic expansion and stable prices.
Traders trimmed bets on a rate increase in the next three months after the announcement. Odds that the Fed will keep its benchmark at 2 percent in September rose to 23 percent today from 2 percent a week ago, according to futures contracts quoted on the Chicago Board of Trade.
``I don't think they are signaling a rate hike as a possibility at the next meeting,'' said Cary Leahey, senior economist at Decision Economics Inc. in New York. ``Before they would tighten credit, they would have a statement that would say `we do have a tightening bias' and they would say that as clearly as they can.''
Bernanke Message
Yesterday's statement reflected Fed officials' comments this month that the central bank must keep price expectations in check to avoid a spiraling in inflation. Bernanke said June 9 that officials would ``strongly resist'' a jump in those expectations.
The FOMC cited ``the elevated state'' of some measures of inflation expectations, and dropped an April forecast of a ``leveling out'' in commodity prices.
The decision wasn't unanimous, with Dallas Fed President Richard Fisher dissenting for a fourth straight time, favoring the first rate increase in two years.
Oil prices touched a record $139.89 June 16, extending a rally that helped push the consumer price index up 4.2 percent in the 12 months to May compared with an average of 2.7 percent over the past decade.
Dow Chemical Co. said two days ago that higher raw materials costs will cause the company to raise prices by as much as 25 percent in July, following an increase of as much as 20 percent. United Parcel Service Inc. cut its second-quarter profit forecast June 23 because of rising fuel costs and slowing U.S. growth.
`Tentative Signs'
``Higher headline rates of inflation have shown only a few tentative signs of embedding themselves in core inflation or in longer-term inflation expectations,'' Fed Vice Chairman Donald Kohn said in a speech to a conference today in Frankfurt.
American consumers foresee average annual inflation of 3.4 percent over the next five years, the highest expectation since 1995, according to the Reuters/University of Michigan survey. The five-year outlook among investors has been more stable, at 2.43 percent, up from 2.31 percent in January, according to a measure derived from inflation-linked Treasuries.
``What they're saying is, we have a duty to price stability, and we want you to know that we are mindful of that duty, but we may not think it's appropriate to act on that duty in the short run,'' said Neal Soss, chief economist at Credit Suisse in New York, who used to work as an aide to former Fed chief Paul Volcker.
Financial Stress
Credit markets have yet to normalize and bank losses are mounting as the economic slowdown adds to stresses from the subprime mortgage collapse. The gap between investors' expectations for the Fed's main rate and the rate that banks charge each other for funds increased this month, a sign of continued turmoil.
The difference between the three-month London Interbank Offered Rate and the overnight index swap rate widened to 0.73 percentage point yesterday from 0.68 point at the end of May. Former Fed chairman Alan Greenspan said this month the credit crisis will be over when the spread narrows past 0.25 point.
The worst housing recession in a quarter century is showing few signs of ending. Reports this week showed sales of new homes extended their decline in May, consumer confidence dropped to a 16-year low and orders for durable goods stagnated.
Yesterday's statement contained no mention of the contraction in gross domestic product that many officials judged likely at their April meeting. The Commerce Department today lifted its estimate of GDP growth for the first quarter to a 1 percent annual pace, from a previous estimate of 0.9 percent.
``I hope we'll be in good enough shape by later in the year'' that the Fed could raise rates, House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, said in an interview with Bloomberg Television. Frank added he was ``skeptical'' there will be sufficient improvement by then.
To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net
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