Jawboning the dollar may bite Federal Reserve

By Emily Kaiser - Analysis

WASHINGTON (Reuters) - The unrelenting rise in oil prices has put U.S. Federal Reserve Chairman Ben Bernanke in the precarious position of trying to talk down inflation without raising interest rates.

The result may be a blow to the central bank's credibility, just as Bernanke was finally winning plaudits from many on Wall Street for his handling of the credit crisis.

"They've painted themselves into a corner," said Gabriel Stein, an economist at Lombard Street Research in London. "I think the Fed is losing credibility by the buckets right now."

The Fed is expected to keep its benchmark federal funds rate unchanged at 2 percent when its policy-setting committee meets this week. It has more than halved rates since mid-September in a bid to prevent the housing slide and credit contraction from triggering a deep recession.

But as the U.S. economy weakened in recent months and rates fell, the dollar's slump deepened. That has contributed to rising prices for oil and other commodities that are priced in dollars, and has also made imports more expensive.

Overall inflation rose by an uncomfortably high 4.2 percent year-over-year in May, which under normal circumstances might have encouraged the Fed to raise rates. The trouble is, the economy remains fragile, as evidenced by the persistent rise in unemployment, the still-weakening housing market, and a slowdown in manufacturing.

And it is not just a U.S. problem. Inflation is running at the highest level in more than a decade in China and India. Mexico's central bank raised borrowing costs for the first time in eight months on Friday to tackle inflation stemming primarily from soaring food prices.

"The dilemma now faced by the (Fed's monetary policy) committee is that while the economy has not collapsed, it is not exactly providing signs of an imminent recovery," said Joseph Brusuelas, chief economist with Palo Alto, California-based Merk Investments.

The Fed "is caught in between what it should do -- raise rates -- and what it needs to do, remain on hold."

BERNANKE VS TRICHET

In a speech earlier this month, Bernanke tried to tackle price pressures another way, by raising concerns about the inflationary impact of the falling dollar. That caught investors' attention because it is unusual for the Fed chairman to talk about currency matters, which are normally the purview of the Treasury secretary.

While Bernanke's comments sent the dollar higher and cooled the oil rally, markets reversed course just days later when Bernanke's European Central Bank counterpart, Jean-Claude Trichet, said an ECB rate hike could come as early as July.

That prompted some investors to speculate that there may be a rift between the two central banks, although sources on both sides of the Atlantic dismissed that idea.

Still, whether there is bad blood or not, the gap between U.S. and euro zone interest rates looks likely to widen further, and that could put more pressure on the dollar -- and provide more fuel to the oil market.

If the ECB raises its rate by one-quarter of a percentage next month as expected, it would stand at 4.25 percent, more than double the federal funds rate. That would encourage currency traders to dump dollars in favor of higher yielding euros.