Fed seen holding rates steady, eyeing prices

By Mark Felsenthal

WASHINGTON (Reuters) - The U.S. Federal Reserve is expected to hold interest rates steady at a meeting this week and suggest it is in no rush to raise them, even as it acknowledges some troubling signs on the inflation front.

Surging oil prices and lingering financial-sector weakness are clouding some hopeful signs that the U.S. economy has weathered the worst of a credit crisis and is poised to work its way through a period of sluggishness with the help of low interest rates and the government's fiscal stimulus handouts.

While record-high oil and gasoline costs risk upsetting the Fed's forecast for slowing inflation, officials also remain concerned that the economy has yet to find solid footing.

When they announce their rate decision at the end of a two-day meeting on Wednesday, Fed policy-makers are expected to voice discomfort on the inflation front, but stop short of signaling a near-term rate increase was imminent.

"While downside risks to growth undoubtedly remain, upside risks to inflation have intensified," Global Insight economists Brian Bethune and Nigel Gault wrote in a note to clients.

TOUGHER TONE ON INFLATION

After its last meeting April 29-30, the U.S. central bank said the combined 3.25 percentage points in rate cuts put in place since mid-September, in conjunction with extraordinary measures to provide emergency liquidity to struggling financial markets, should steer the economy back to steady growth.

Top Fed officials speaking in recent weeks have portrayed an economy that looked to have skirted a deep recession even though the unemployment rate spiked to 5.5 percent in May, the highest in more than 3-1/2 years.

At the same time, the Fed's top two policy-makers, nodding to oil prices that climbed to a record above $139 a barrel in early June, took a decidedly tougher tone on inflation risks.

Higher raw materials costs have so far not pushed up the prices of other goods or wages, Fed Chairman Ben Bernanke said on June 9, but he warned that could change.

Bernanke further promised to "strongly resist" any trend of public expectations of higher inflation, while Fed Vice Chairman Donald Kohn cautioned that any rise in longer-term inflation expectations would have "troublesome" implications.

The Fed believes "core" prices that strip out volatile energy and food costs are the best measure of inflation trends, and those costs were relatively tame in May. But the central bank places great emphasis on making sure expectations of future inflation do not rise in a way that could trigger a self-perpetuating upward spiral of wages and prices.

MARKET OVERREACTION

Even so, the Fed let it be known that market assumptions that those remarks presaged a series a rate rises before year-end were premature and that at least some policy-makers continued to harbor serious worries about risks to growth.

Markets scaled back expectations of higher rates and chances that the first increase in borrowing costs could come in August, which had been priced in as a near certainty, slipped to as low as 43 percent as implied by short-term interest rate futures.