Low inflation making Fed's job easier for now

Federal Reserve Chairman Ben Bernanke prepares to speak at the December luncheon meeting of the Economic Club of Washington, in this December 7, 2009 file photo.

WASHINGTON (Reuters) - For Federal Reserve officials looking to finesse their way out of a historic array of emergency lending programs, the recent pullback in oil prices could not have come at a more opportune time.

The U.S. central bank meets this week to set the course of monetary policy and is not expected to make any changes to its ultra-stimulative low interest rate policy, particularly since inflation pressures remain tame for the time being.

However, at a time of lingering uncertainty about the global economic outlook, investors are likely to hang on the Fed's every word for clues into the timing of any potential move toward the exits.

Because of the dollar's role as a reserve currency, the Fed is the closest thing the world has to a global central bank. That is why investors spend so much time foraging for clues on its next move.

As things stand, the central bank will probably acknowledge a recent improvement in the economic backdrop but maintain its pledge to keep rates near zero for an "extended period." Supporting the Fed's ability to do so, oil prices have come down from their October highs and the dollar has rebounded after hitting 15-month lows, both of which suggest inflation will not be a near-term concern.

Still, with U.S. job losses decelerating and consumer spending showing some momentum, pressure is mounting for policymakers to define their exit strategy more concretely.

Indeed, many have begun to wonder whether the recent run-up in asset prices that has lifted emerging market stocks from Latin America to Asia at a breakneck pace could be the beginnings of a liquidity-fueled bubble.

"The Fed's quantitative easing program has probably distorted a lot of relationships in the financial markets," said Jim DeMasi, chief fixed-income strategist at Stifel Nicolaus in Baltimore.

TOO COMFORTABLE?

In order to fend off the worst financial crisis since the Great Depression, the Fed not only slashed interest rates effectively to zero but also created a smorgasbord of new lending facilities that have flooded the financial system with over $1 trillion in funds.

These measures are widely credited with pulling the banking sector back from the brink, potentially preventing an even deeper recession. They have also allowed financial markets to stabilize, making investors more comfortable taking risks.

The worry has now become, are they getting too comfortable?

"We are very concerned about the risk of an asset bubble," Hong Kong's Financial Secretary John Tsang said last week.

Countries around the world, have taken steps to try to limit the amount of "hot money" flowing into their borders. Brazil and Taiwan have imposed capital controls to try to limit the inflows, and many others are considering what steps they could take.

Arminio Fraga, a former president of Brazil's central bank, recently told reporters in New York: "In many ways we have a bubble machine still on. We're treating a bubble with a bubble."

Mindful of such risks, the European Central Bank has announced it is ready to begin unwinding some its own emergency facilities. Analysts will get a better sense of business conditions in Europe on Tuesday with the release of Germany's ZEW economic sentiment survey. That index has been falling back of late after a steep recovery, and estimates suggest it will dip further to 50.0 this month.

WHAT'S A FED TO DO?

Bernanke, asked about the problem of bubbles during Congressional testimony earlier this month, argued the Fed could not be responsible for monitoring asset values outside the United States.

"It needs to be understood that United States monetary policy is intended to address both financial and economic issues in the United States," Bernanke said. "Countries which are concerned about that have their own tools to address bubbles in their own economies."

As for its domestic outlook, the Fed could offer some nod to the brighter tone of recent economic reports.

"The economy is showing signs of better activity, and we will see that increased optimism show up in their statement," said Michael Strauss, chief economist at Commonfund in Wilton, Conn.

Inflation data due out Wednesday should largely support the Fed's super-loose policy stance. Consumer prices, on the rise again following a period of outright declines, are climbing at a pace that monetary officials deem acceptable.

Economists on median see a 0.4 percent gain in the November consumer price index, but mostly due to higher energy prices that have since come back down. Oil prices peaked at $82 a barrel back in late October, and are now close to $70.

Outside food and energy, the CPI was seen rising just 0.1 percent, pushing the year-on-year core index most closely watched by the central bank up 1.8 percent, below the Fed's implicit 2 percent target.

Inflation expectations, another key variable in the central bank's policy calculus, were down sharply in early December, according to the Reuters/University of Michigan survey of consumer sentiment.

The benign price outlook, whose flipside is a troubling decline in wages globally, buys the Fed some time to leave borrowing costs on hold. That does not mean, however, that the clamoring for direction from markets will quiet any time soon.

(Reporting by Pedro Nicolaci da Costa; Editing by Andrew Hay)