With inflation monster tame, Fed can manage risk

By Ros Krasny - Analysis

CHICAGO (Reuters) - With inflation pressures relatively tame for now, the Federal Reserve appears to have a wide-open window to pursue a "risk management" interest rate policy that insures against a steep economic downturn created by the housing market slump.

Recent mild inflation data has been applauded by policy-makers, and even as the dollar sags and crude oil prices climb many Fed watchers guess that inflation will stay contained by anemic economic growth.

"The cost of cutting with regard to inflation risk is low, but the cost of doing nothing in terms of economic growth may be high," said Cyril Beuzit, economist at BNP Paribas.

The Fed's Open Market Committee meets Tuesday and Wednesday to decide its next move. In September, the central bank surprised markets with an aggressive 50 basis point cut in the federal funds rate, its first in more than four years. That took the key lending rate to 4.75 percent from 5.25 percent.

Financial contracts handicapping expectations on Fed rate policy show a one-quarter basis point rate cut is fully priced for the upcoming meeting, with another half-point move not out of the question.

Fed Chairman Ben Bernanke is thought to favor the increased "juice" that the bank can get from markets if it does more than simply match expectations with policy moves.

With that in mind, a significant minority of bets has been placed on a 4 percent fed funds rate by year end, or 75 basis points in cuts at the next two FOMC meetings.

Deep into the quarterly earnings season, businesses such as freight-hauling companies are keeping up a drumbeat of talk about recession as the residential housing slowdown drags consumers to the ground.

Housing-related consumption accounts for more than a quarter of total U.S. consumer spending.

On Friday the Reuters/University of Michigan consumer sentiment survey dropped to its lowest level since May 2006 -- the month when U.S. gasoline pump prices made record highs.

The report arguably helped give the Fed a freer hand, with inflation expectations contained despite recent increases in crude oil prices.

Even so, inflation is not gone. Inflation breakevens shown in Treasury Inflation Protected Securities (TIPS) are back on the rise. On Friday 10-year TIPS spreads showed inflation expectations of 2.37 percent, the highest since July.

"Inflation hasn't warranted a place at the top of the trouble table recently, but it bears watching," said Carl Tannenbaum, chief economist at LaSalle Bank. "Certainly (it is) no time to become complacent."

DOLLAR WOES CONTAINED?

The Fed is also grappling with an unprecedented fall in the value of the U.S. dollar.