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Inflation Signs Mount, Despite Slow Growth

In minutes of its January meeting the Federal Reserve's fretting about rising prices is trumped by fear of a downturn.
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Updated from 12:10 p.m.

The threat of inflation keeps challenging the widespread belief that the

Federal Reserve

will continue printing money to keep financial markets afloat through the current credit crisis.

The latest challenge came Wednesday morning, when the government reported that its consumer price index rose 0.4% in January. The core CPI, which excludes volatile food and energy prices, was up 0.3%. Both readings exceeded expectations on Wall Street and spooked an already fragile stock market.

In minutes from the last Fed meeting released Wednesday afternoon, the central bank revealed that officials generally agreed that inflation data since December has been "disappointing," but the Federal Open Markets Committee agreed to cut its key interest rate target by a half-point anyway to combat the risks of an economic downturn.

"With no signs of stabilization in the housing sector and with financial conditions not yet stabilized, the committee agreed that downside risks to growth would remain even after this action," the Fed said in the minutes of its two-day meeting ended Jan. 30.

Some members of the committee noted that when prospects for economic growth improve, rates can be raised back up -- possibly in a rapid fashion -- to head off inflation. Many members said an economic slowdown anticipated in the first half of 2008, coupled with a "leveling-off" of energy and commodity prices, should ease inflation pressures.

Since then, energy and commodity prices have continued to spike higher, but the fed funds futures showed that investors aren't retreating from a near unanimous certainty that the Fed will again slash its key interest rate target by another half a percentage point in March. It has already lowered the fed funds rate by 225 basis points since September, even as inflation has climbed steadily higher.

"The fixed-income markets remain broken," says T.J. Marta, fixed-income strategist with RBC Capital Markets. "The Fed needs to ensure that the banking system can survive and part of doing that is steepening up the yield curve. It's a lousy situation."

The situation is made even lousier by rising commodity prices, including those for agricultural products. The price of wheat has more than doubled since last May. Crude oil prices are hovering around $100 a barrel, which flies in the face of the long-held Fed view that energy prices will moderate. Also, food costs climbed 0.7% in January.

Inflation has also shown up in some corporate earnings reports. The world's largest retailer,

Wal-Mart

(WMT) - Get Walmart Inc. Report

, reported a fourth-quarter sales increase of 8.3% that was largely powered by new store openings and increases in food and energy prices. Its sales at stores open for at least a year rose 1.6% for the quarter, but excluding fuel sales, they were up 1.4%. The company doesn't break out food prices.

"Wal-Mart's sales were likely much weaker than the headline number, reflecting inflation," says Barry Ritholtz, chief investment officer with Fusion IQ and a contributor to RealMoney.com, a sister site to

TheStreet.com

. "We suspect that's why the company lowered its

outlook for the current quarter and the full year."

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Consumer prices rose 4.3% on a year-over-year basis in January, which marks the biggest increase since September 2005. The core CPI was up 2.5% compared to January 2007, still the highest annual rate since last March. Over the past three months, core inflation has risen at a 3.1% annual rate, well above the Fed's presumed comfort zone of around 1.5% to 2%.

In the last Fed meeting, Dallas Fed governor Richard Fischer dissented from the vote to ease rates, preferring to hold pat after supporting a three-quarter point emergency rate cut announced after a global selloff in the stock market earlier in January.

"Given these actions,

Fischer felt that monetary policy was already quite stimulative, while headline inflation was too high at more than 3% over the last year," said the Fed minutes. "Demand-pull inflation pressures from emerging-market economies abroad appeared to be continuing, and anecdotal reports from business contacts suggested greater willingness domestically to pass rising costs through to prices."

Fischer was concerned that inflation expectations could become "unanchored" and "pervasive," and he noted that the economy still seemed to be growing, albeit at a weakened pace.

Former Fed governor Lyle Gramley, now a senior economic advisor with Stanford Financial Group, notes that several Fed officials have recently expressed concerns about inflation threats, and some of those who have issued warnings are not those who have a reputation for being particularly hawkish on inflation.

"I've been one that has been anticipating a 50 basis point cut next month, but you have to reckon with the fact that the Fed has got to be worried -- not just about the inflation numbers that are coming in, but the uptick in inflation expectations -- a point that they are very focused on," Gramley says.

Fed Chairman Ben Bernanke said just last week in testimony before Congress that, "any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank's policy flexibility to counter shortfalls in growth in the future."

When the minutes from the Fed's January meeting are released later on Wednesday, investors will get more perspective on the central bank's thinking going into March. That said, the Fed did not have the latest inflation data at its last meeting, which Ian Shepherdson, chief U.S. economist with High Frequency Economics, called "a bit disconcerting" in a note to clients that followed the release.

"This report will make it much easier for the Fed to ease only by 25 basis points on March 18 -- though

February's employment report could change that," said Shepherdson.

The Labor Department reported the first monthly contraction in the U.S. job market on record in more than four years in January, lending credence to predictions that problems in the housing and credit markets are spilling over into the broader economy and causing a recession. That armed the Fed with more authority to ease interest rates to avoid an economic downturn.

That said, the Fed has been widely criticized for being a root cause of the housing bubble that developed in the early part of this decade by keeping interest rates at historically low levels for years after the terrorist attacks of Sept. 11, 2001. That encouraged a borrowing binge on the part of consumers, homeowners and lawmakers in Washington, D.C.

The eventual downturn of the U.S. housing market, which is now showing price declines the likes of which have not been seen since the Great Depression, is what ignited the credit crisis that is crippling the world's financial markets. Critics say that by pouring more cheap credit on the problem, the Fed is essentially pouring gasoline on a forest fire and opening the door to more asset bubbles and price instability.

Moreover, critics accuse the Fed of devaluing the dollar by pumping so much liquidity into the economy. The value of the dollar plunged in comparison to competing currencies last year, hurting the purchasing power of U.S. consumers and potentially stoking inflationary forces.

Despite all this, market participants say the slowdown that's facing the U.S. economy will take care of inflation on its own and the Fed should be focused now on preventing a full-blown meltdown of the financial markets.

"There's a big question as to whether or not the downward trajectory of the economy is going to take care of inflation all by itself," says Marta.

Gramley says there remains a better than 50-50 chance that the Fed will cut interest rates by another 50 basis points in March, but he says it's by no means a certainty.

"In a situation of this kind, the Fed has to use its risk-management approach to monetary policy, reckoning with the fact that a collapse of the economy is a low probability, but if it occurs, it's really a devastating thing," says Gramley. "So, they have to provide some insurance against that."