Fed: High energy, food prices keep economy weak

[June 12, 2008]  WASHINGTON (AP) -- The economy remained "generally weak" heading into summer as rising costs for energy and food pounded consumers and forced some companies to push their own prices higher.

The Federal Reserve's new snapshot of business conditions, released Wednesday, underscored two big sore spots for the country: listless economic activity coupled with high energy and food prices. Those rising prices carry the risk of both spreading inflation and putting another drag on overall economic growth.

Chafing under price hikes, "consumer spending slowed ... as incomes were pinched by rising energy and food prices," the Fed said. Manufacturing activity, meanwhile, was "generally soft" and the housing market remained stuck in a rut.

Businesses also were hit by higher costs, especially for energy, metals, plastics, chemicals and food. Such reports were "widespread," the Fed said. To cope, manufacturers in several areas "noted some ability to pass along higher costs to customers" the Fed said. Retailers, however, reported "mixed results with respect to raising final goods prices," the Fed said.

Over the past week, Fed Ben Bernanke and his colleagues have been sounding an ever-louder alarm against inflation. Given those concerns, Bernanke has signaled the Fed's rate-cutting campaign, started last September to bolster the weak economy, is probably over.

Many economists predict the Fed will leave its key rate at 2 percent, a four-year low, when it meets next, on June 24-25.

For now, "policymakers won't raise rates because of concerns about the economy, but they can't lower them because of concerns about worsening inflation. So it's basically a stalemate. The right thing for the Fed to do is to leave rates alone," said Stuart Hoffman, chief economist at PNC Financial Services Group.

However, with inflation moving up on the Fed's list of concerns, Wall Street investors and others are now thinking the Fed might be forced to start boosting rates later this year to curb inflation.

On Wall Street, stocks tumbled as soaring oil prices fanned inflation concerns. The Dow Jones industrials plunged 205.99 points. Oil prices closed at $136.38 a barrel. Gasoline prices reached another record -- a national average of $4.052 a gallon.

One of the things the Fed will be paying close attention to is the extent to which people think prices will keep going up, something that can make them act in ways that would worsen the inflation climate. If such "inflation expectations" were to "drift higher or even to fail to reverse" that would have "troublesome implications," Donald Kohn, the Fed's vice chairman, said in a speech Wednesday.

James Bullard, president of the Federal Reserve Bank of St. Louis, echoed that point. "It is rule No. 1 in modern central banking that inflation and inflation expectations be kept under control," he said.

Raising rates too soon, though, could deal a set back to the already fragile economy.

It's a dicey situation for Fed policymakers.

The housing, credit and financial crises have badly bruised the economy and sharply slowed its growth. Consumers and businesses alike have hunkered down. Employers have cut jobs every month so far this year and the unemployment rate zoomed to 5.5 percent in May, from 5 percent in April -- the largest one-month increase since 1986.

Bernanke, in a speech earlier this week, downplayed the big jump in the jobless rate, saying the danger that the economy has fallen into a "substantial downturn" appears to have waned over the past month or so.

The Fed's powerful doses of interest rate cuts, the government's $168 billion stimulus package, further progress in the repair of problems in financial and credit markets, a gradual ebbing of the drag from the deep housing slump and still solid demand from abroad for U.S. exports should help the economy over the remainder of this year, Bernanke predicted.

At the same time, Bernanke sent a fresh warning that the Fed will be on heightened alert against inflation dangers, especially any signs that investors, consumers and businesses are thinking inflation will get worse.

The Fed "will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation," the Fed chief said Monday evening.

With hiring slowing, the Fed's report on Wednesday suggested there's little danger of wage inflation taking off. Wage pressures were reported as "moderate or limited for all but a few skilled-labor positions," the Fed said. That's consistent with Bernanke's recent assessment that he doesn't see a repeat of the 1970s-style situation where workers demanded -- and received -- higher wages to keep up with ever-rising prices.

The Fed's survey is based on information supplied by the Fed's 12 regional banks. The information was collected before June 2.

In the short term, it may be that some rise in both inflation and unemployment will have to be tolerated, Kohn suggested.

Setting interest rates "in a manner that balances the undesirable effects of a shock to the system on both inflation and employment will tend to be more efficient than setting policy so as to deliver more extreme outcomes in either inflation or unemployment," he said.

[Associated Press; By JEANNINE AVERSA]

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