Fed to hold rates even as inflation fears rise

By Pedro Nicolaci da Costa

NEW YORK (Reuters) - The Federal Reserve will leave interest rates on hold for now as ongoing fears about the economy trump any inclination to tighten monetary policy in order to fight inflation, according to a Reuters poll.

The survey did indicate, however, that concerns about a deeper economic downturn have receded, despite a report on Friday showing the biggest one-month spike in the unemployment rate since the mid-1980s and another record-setting day in the oil markets.

Wall Street primary dealers -- banks that deal directly with the central bank -- see the Fed leaving rates on hold at both its June and August meetings.

"The combination of rising unemployment and rising inflation expectations just leaves (us) totally frustrated and powerless," said Brian Fabbri, senior economist at BNP Paribas.

A few investors still believe a worsening growth outlook will force policy-makers to cut rates further from the current 2 percent, but they are a minority. The median forecast for fed funds at year-end was 2 percent, up from 1.75 percent in an April 30 poll.

In fact, many are beginning to ponder an eventual rise increase in borrowing costs as Fed officials step up their rhetoric about inflationary concerns.

But that is unlikely to come any time soon, the poll indicates, with a downtrodden housing market a key risk to consumer spending and broader economic activity.

The Reuters survey comes on a wild day for the markets. Major stock averages fell

about 3 percent, with the Dow having its worst day in more than a year. Meanwhile, oil prices jumped over 7 percent, closing the day at a record $138.54 a barrel.

Meanwhile, the economy shed 49,000 jobs in May, pushing the jobless rate up to 5.5 percent.

"This makes it even harder for the Fed to contemplate a rate hike before the

election," said Cary Leahy, economist and managing director at Decision Economics. "Even (Paul) Volcker did not start to raise rates when the unemployment rate was rising significantly," referring to the man who led the central bank through the 1980s.

The Fed has cut rates sharply since a credit crisis that started last summer, when officially-set borrowing costs stood at 5.25 percent.

(Additional reporting by Pam Niimi, Chris Reese, John Parry, Burton Frierson, Ellen Freilich and Richard Leong; editing by Gary Crosse)