Fed likely on hold for a while unless challenged

By Mark Felsenthal - Analysis

WASHINGTON (Reuters) - The U.S. Federal Reserve looks set to keep interest rates on hold for an indefinite period despite disturbingly high inflation, as weak housing markets and tight credit weigh on the world's largest economy.

However, officials at the Fed -- the U.S. central bank -- are also nervously watching inflation, which at 5 percent over the 12 months to June was the highest in more than 17 years, and would act if its dynamics took a sharp turn for the worse.

In recent weeks, the Fed's inflation fears may have eased somewhat. Oil prices have climbed down from record heights and the public's expectations for future inflation have receded.

While some Fed officials have said the central bank should begin to raise benchmark rates soon to combat inflation, more strident anti-inflation hawks are likely to be no more than dissenters in Fed decisions to hold rates steady at 2 percent.

When Fed policy-makers gather next Tuesday to consider interest rate policy it will be hard to argue, with six consecutive months of net job losses and home resales at the lowest in 10 years, that the U.S. economy is overheating.

"The economy continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food and some other commodities," Fed Chairman Ben Bernanke told Congress this month.

"The housing market is really the central element of this (financial) crisis, and anything we can do to strengthen the housing market, to strengthen mortgage finance, would be beneficial," he said.

GLOBAL DEMAND

The disconnect between high inflation and a weak economy, and clues to Fed strategy to deal with both, have to do with underlying causes. Oil and commodity prices have been pushed up by surging global demand from emerging market economies.

"The Federal Reserve cannot create another barrel of oil," Bernanke told lawmakers frustrated with rising gasoline prices. "It's the global supply and demand conditions which are affecting those particular things to the most significant extent."

In the United States, there is little evidence that wages and prices outside of the food and energy arena are spiraling higher amid the wreckage of the deep housing slump and the continued credit shake-out.

Though businesses are facing higher production costs, they are having a hard time passing those costs along to consumers, and workers in a competitive and weakening labor market have little leverage to demand higher salaries.

"The extent to which the high prices of oil and other raw materials have been passed through to the prices of non-energy, nonfood finished goods and services seems thus far to have been limited," Bernanke told Congress on July 15.

A week later, the Fed's Beige Book survey of economic conditions noted wage pressures had been "generally limited" as businesses showed little desire to hire aside from a need for skilled labor and more workers in the energy sector.

BREATHING ROOM