Inflation sparks glowing on the horizon

By Emily Kaiser

WASHINGTON (Reuters) - U.S. Federal Reserve Chairman Ben Bernanke must find a convincing way to explain why his central bank is in no hurry to raise interest rates even though the economy is stabilizing.

With mounting evidence that the recession is loosening its grip on the economy -- even if a healthy recovery is far from assured -- investor focus is shifting to inflation.

The Fed thinks that with unemployment at a 26-year peak and idle factory space at its highest on record, there is little near-term risk of prices overheating. That gives the central bank cover to keep borrowing costs low until it deems the economy strong enough to handle a rate hike.

But for some investors, it is not so clear cut. While there may be plenty of slack now, they worry that because the Fed and its counterparts around the world have been printing money to short-circuit the credit crisis, inflation is the inevitable consequence.

This puts Bernanke and his policy-setting team in a tricky position as they convene for a two-day meeting beginning on Tuesday. They will need to downplay inflation now, but reassure investors that they are willing and able to withdraw the flood of money before it causes trouble.

Dino Kos, managing director at the research firm Portales Partners and a former top Fed official, said as long as the weak economy chills demand for credit, the free-flowing central bank cash poses no inflation threat. But the Fed will have to time its exit strategy just right.

"If this is kindling right now, there is no spark to get it going," he said, adding that the Fed must be vigilant because "there's some sparks that are getting closer."

Economists polled by Reuters see no chance that the Fed will raise its benchmark short-term interest rate from the current level near zero at this week's meeting. That said, the central bank will probably want to nurture hopes that the end of the recession is nearing.

The Fed may use its closely watched statement at the end of the meeting Wednesday to convey the message that while the economy appears set to resume growth over the next few months, interest rates will stay low for a while, said Dean Maki, an economist with Barclays Capital in New York.

Indeed, economists advising the American Bankers Association said last week that there may be four consecutive quarters of positive U.S. economic growth before the Fed is ready to budge, probably in the third quarter of 2010.

Before the Fed is ready to raise interest rates, it will probably take a sharp knife to the $2 trillion balance sheet it built up by buying assets to try to spur the economy. The Fed has committed to buy up to $1.75 trillion of U.S. government and mortgage-linked debt, and still has a long way to go.

However, it looks unlikely the Fed will decide this week to ramp up those purchases, something that had been a hot topic just a couple of weeks ago. Many economists now think such a step could backfire if investors see it as more fuel for the inflationary fire.

JAPAN OR ZIMBABWE?

Goldman Sachs economist Jan Hatzius said there was so much disagreement among investors about the path of inflation that he has heard forecasts ranging from Japan-style deflation to hyperinflation. His personal view is similar to the Fed's -- there is enough slack in the economy to ward off inflation.

Those who see inflation looming on the horizon point to the research of legendary Nobel prize-winning economist Milton Friedman, who argued that inflation is always and everywhere a monetary phenomenon.