Inflation Fears Could End Fed's Fiddling

With food and energy prices soaring around the world and the value of the U.S. dollar declining, financial markets are starting to ponder the limits of easy-credit policies from the Federal Reserve.

The specter of global inflation has caused a shift in expectations for the central bank's next decision on interest rates, which will be announced next Wednesday. The futures market was recently pricing in a 96% chance of a 25-basis point cut to the fed funds rate, and a number of economists predict the Fed will halt its series of rate cuts after its April meeting.

"After next week, they're going to be in a wait-and-see mode," says Ryan Sweet, economist with Moody's Economy.com. "More likely than not, they're going to leave the fed funds rate at 2% and see how the economy rebounds in the second half of the year."

One week ago, the market was priced for 40% odds of a 50-basis point cut, which would have brought the Fed's key short-term interest rate target down to 1.75%. A month ago, the market saw 100% odds of a 50-basis point cut and 64% odds of a 75-basis point cut.

The shift has come as the stock market has clawed back from its 52-week low and credit fears have eased, but economists say the decline in odds of a rate cut has more to do with rising signs of inflation and fears that further monetary easing from the Fed will allow prices to spin out of control.

"Inflationary pressures that have been gradually building are driving the shift, and the Fed is going to start being more cautious," says Sweet. "The housing recession and credit crisis is testing the limits of traditional monetary policy, so the central bankers are more likely to focus on the new lending facilities that have been created in an effort to relieve some of the pressure on interbank lending rates."

The Fed has slashed its rate target by 300 basis points since the outbreak of the credit crisis last summer. Still, widened credit spreads only began to narrow after the Fed aided JPMorgan Chase'sJPM purchase of Bear StearnsBSC, which was on the brink of bankruptcy in mid-March, and extended credit to Wall Street investment banks through a series of new lending facilities under authorities the central bank had not exercised since the Great Depression.

The implicit government backing of investment banks and mortgage giants like Fannie MaeFNM and Freddie MacFRE also was welcomed by financial markets.

Inflation Concerns Rise

Inflation concerns, however, are again on the rise. On Tuesday, the dollar hit an all-time low of $1.5991 against the euro, and crude oil closed at an all-time high of $119.37 a barrel.

Two members of the rate-setting Federal Open Markets Committee have fretted over the rising inflationary pressures. Richard Fisher and Charles Plosser dissented from the Fed's decision to lower rates by 75 basis points in March, preferring less aggressive action at the meeting. The Fed minutes from its March meeting revealed that both men dissented out of concerns that expectations for inflation in the U.S. economy will become "unhinged" as the dollar drops in value while commodity prices rise.

"Mr. Fisher stressed the international influences on U.S. inflation rates," said the minutes. "Mr. Plosser noted that the committee could not afford to wait until there was clear evidence that inflation expectations were no longer anchored, as by then it would be too late to prevent a further increase in inflation pressures."

Paul Volcker, the former Fed chairman who slayed inflation in the 1970s by cranking up interest rates -- despite howls of protest on Wall Street -- said in a recent speech at the Economics Club of New York that the U.S. dollar is in "crisis" and inflation is a concern.