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Fed Likely to Sit Tight, as Inflation Fears Rise

The Fed is expected to keep its target rate near zero, but the market will be looking for hints as to when and how the central bank will unwind stimulus programs.



) -- The

Federal Reserve

will not keep interest rates near zero forever and recent signs of the economy's improving health have some investors fretting that day will come sooner rather than later.

Recent economic releases point to gradual improvements across housing, labor and consumer markets, ahead of the Federal Open Market Committee's interest rate decision Wednesday afternoon. The Fed has been reiterating its intention to keep rates low for an extended period, as long as unemployment remains high and the inflation outlook is stable.

But signs are beginning to mount that those two factors are shifting.

Wholesale prices

, measured by the producer price index, jumped 1.8% in November, the Labor Department reported Tuesday. That easily outpaces expectations and poses a direct challenge to Bernanke's recent comment that high unemployment would keep inflation concerns subdued. The

consumer price index

for November, released by the Labor Department Wednesday, met expectations for a rise of 0.4%.

Jobs Will Drive Rate Hike

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The inflation news comes on top of a November nonfarms payroll report released earlier this month that showed a loss of 11,000 jobs vs. the projected 125,000 decline and the recent moves by the most troubled big banks to climb out from under the government's bailout aid distributed through the Troubled Asset Relief Program last year.

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in the past two weeks have taken steps to issue common stock and repay the government's investment.

Although the FOMC is widely expected to keep rates unchanged when it delivers its statement Wednesday at 2:15 p.m. EST, the market will be paying close attention to the language of the decision, trying to gauge how soon the Fed will start unwinding stimulus used to prop up a sagging economy.

"The Fed's last comments in November emphasized that the economy is improving and that inflation is in control. I'd expect the message

Wednesday to be similar," said Wayne Schmidt, president and chief investment officer of Gradient Investments, who doesn't anticipate a rate change until mid-2010. "The statement will probably allude to the fact that the economy is getting stronger and growth remains a central concern."

Some economists suspect markets may take any suggestion of upcoming unwinding as a negative. But Schmidt believes bond market activity -- especially after Tuesday's producer price index data -- indicates that the market is already anticipating the draining of liquidity.

"With the benchmark 10-Year Treasury up 40 basis points in December, the market is saying that it sees the economy improving and that it's anticipating the Fed having to tighten monetary policy in 2010," Schmidt said.

Investors will also be looking for indications about how the Fed plans to rein in its balance sheet, but UBS economist Maury Harris doesn't expect Wednesday's statement to go into the gritty details.

"We believe the Fed's policy paragraph should reiterate that the funds rate will likely remain 'exceptionally low,' 'for an extended period,' but may not elaborate on the mechanisms being considered to manage the Fed's balance sheet, which instead should be presented in the later released FOMC minutes," Harris wrote in a recent note.

Joseph LaVorgna, Deustche Bank's chief U.S. economist, expects the Fed's "extended period" language to remain intact. In fact, the only change he anticipates is a slight improvement in the committee's assessment of the economic outlook.

"We do not believe enough has changed in the last week and a half for the chairman's view to have meaningfully shifted. Moreover, we do not expect the Fed to make any major changes to its various liquidity provisions," LaVorgna says, noting changes to the central bank's mortgage purchases, financing programs or discount rate "could lead to an outsized and destabilizing impact on the financial markets."

"With the sustainability of recovery still in doubt, we do not see why the Fed would make any changes at this point, especially with year-end approaching, when financial markets are notoriously illiquid."


Written by Melinda Peer in New York.