FED FOCUS-Weak growth not enough to bolster rate cut hopes

By Burton Frierson

NEW YORK, April 26 (Reuters) - Whatever upcoming growth figures say about the health of the U.S. economy, they would have to be shockingly weak to persuade the Fed to risk its inflation credibility on interest rate cuts anytime soon.

Financial markets have accepted the likelihood that the figures will show a softening in the economy. They are also aware that troubles in the housing sector and flagging business investment could remain a drag in the months ahead.

Many are therefore betting the Federal Reserve will cut benchmark borrowing costs later this year to shore up growth. But they also know taming inflation remains the Fed's top priority, and price pressures are unlikely to abate as long as unemployment remains near its lowest in six years.

All of this means the Fed probably will not ease policy soon, barring a truly nasty surprise from Friday's numbers.

"The unemployment rate being at a low of 4.4 percent certainly is a concern for the Fed. That is probably one reason why they are not going to be too alarmed about what happens to GDP growth in the first quarter," said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi in New York.

Economists polled by Reuters expected the data to show economic growth, measured by gross domestic product, slowed to a rate of 1.8 percent in the first quarter from 2.5 percent in the fourth quarter last year.

Yet with underlying inflation still running above the Fed's comfort zone of 1-2 percent, analysts say it would take a significantly lower number to prompt the Fed to rush to the economy's rescue.

FINGERS OFF THE TRIGGER

"The trigger for a Fed ease is more likely growth around 1 percent rather than continued growth around 2 percent because we've already seen 2 percent growth leading to a drop in the unemployment rate," said Michael Pond, Treasury and inflation-linked strategist at Barclays Capital in New York.

In the absence of such a surprise, markets may shrug off the first-quarter GDP figures as somewhat dated, especially since the government will release more current jobs statistics in its monthly non-farm payrolls report on May 4.

The probability of revisions will also diminish the value of the release, the first of three estimates on growth.

The GDP report may also leave unsettled the debate between economic bears and bulls. The first camp expects deteriorating growth, led by a housing downturn, to pull inflation lower and ultimately prompt Fed rate cuts.

Others see inflation persisting and growth rebounding later in the year. Some also point to the dynamics of an aging population, which many argue has effectively lowered the economy's growth potential.

It is this very disagreement, in fact, that has kept market interest rates stuck within a relatively narrow range despite a record-setting rally in stocks.

"A lot of the debate that has kept the bond market in a standstill will go on," said Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co.

On Thursday, prices on benchmark 10-year Treasuries US10YT=RR were 8/32 lower on the day, yielding 4.69 percent.

They have been bouncing in a band between this month's peak of 4.78 percent and the three-month low of 4.47 percent they hit in mid-March, when worries were running high over a crisis in the high-risk subprime sector of the U.S. mortgage market.

Certainly a GDP reading around 1 percent would help rate cut prospects and lead to a rally in bonds, which usually benefit from signs of economic weakness.

But even bond-market optimists say the real signal for looser monetary policy will come from employment rather than GDP.

"Quite honestly, I don't think it's going to bring the prospects of rate cuts any closer unless we get rid of the optics of this 4.4 percent unemployment rate," said William O'Donnell, head of U.S. interest rate strategy and research with UBS in Stamford, Connecticut.