The case against U.S. interest rate cuts

By Emily Kaiser

WASHINGTON (Reuters) - If the U.S. Federal Reserve wants to restrain oil and food prices and help downtrodden consumers, the best thing it can do is stop cutting interest rates.

That is the view emerging on Wall Street, among some economists, and even a handful of Fed officials who worry that the world economy is getting only limited benefit from deep rate cuts, but all of the unwanted side effects.

Ending the string of rate reductions that began in September would be welcome news for the European Central Bank, which has held borrowing costs steady while its U.S. counterpart cut, driving the euro to a record high.

It may also be good for developing countries struggling to pay for increasingly expensive food and fuel, and for rich nations worried about inflation eroding economic growth.

The U.S. central bank is set to announce its next move on Wednesday and financial markets still expect a small cut, but the case for standing pat is picking up proponents.

First, there are the Fed officials who argue that lowering the target for overnight rates is not effectively reaching the consumer as other borrowing costs remain high, and who worry further reductions risk stoking already hot inflation. At the Fed's last meeting in March, two of the 10 voting members on the rate-setting committee opposed the three-quarter percentage point cut, preferring less aggressive action.

Then there are the economists who see a direct link between the Fed's sharp moves and the explosive commodity price gains since January.

Now, even investors are beginning to say enough, arguing that consumers may be better off if rates go no lower.

"As central banks pump in liquidity to help bail out the financials, the result so far seems to be ever higher commodity prices," said Andrew Lapthorne, an analyst with Societe Generale in London.

POTATOES AND BONDS

James Hamilton, an economics professor at the University of California, San Diego, thinks the Fed is largely responsible for a recent spike in commodity prices. Since January 22, when the Fed announced a surprise rate cut, the Reuters-Jefferies CRB index .CRB of commodities is up 18 percent.

His argument is that by late January the Fed has pushed real interest rates -- calculated by subtracting out inflation -- into negative territory, sending a signal to investors to buy commodities.

Why? Hamilton explains it with potatoes. Imagine you could buy a potato for $1, or invest that same dollar in a one-year inflation-protected bond. With real interest rates negative, that bond would be worth less in a year, but the potato would be worth the same amount.

His view is not universally held. Fed officials privately say plain old supply and demand are responsible for soaring commodity prices, although they concede a falling dollar has exacerbated the moves.

U.S. Treasury Secretary Henry Paulson said propping up the dollar would do little to ease commodity price pressures.