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As oil muddies outlook, Fed policy less certain

March 10, 2011

Monetary

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By Pedro Nicolaci da Costa

WASHINGTON (Reuters) – Surging oil prices are deepening a split inside the Federal Reserve, blurring the likely direction of monetary policy and making next weeks policy meeting all the more contentious.

The sharp rise in energy costs, precipitated by a wave of pro-democracy uprisings across the Arab world, could affect the economy in different ways, by retarding growth, boosting inflation or, in the worst case, both.

This complicates the terrain for policymakers, hardening long-held positions ahead of the Feds March 15 gathering.

The meeting has definitely gotten more interesting for the participants than theyd like, said Mitch Stapley, chief fixed-income officer at Fifth Third Asset Management.

The stakes are rising, he said. The nightmare scenario is some kind of stagflation outcome. Thats some ways down the road but you begin to see that discussion emerge.

At the heart of the debate is the concept of economic slack, an attempt to measure the gap between current levels of activity and the economys full potential.

The core of the policy-setting Federal Open Market Committee, led by Chairman Ben Bernanke, firmly believes broad price pressures are highly unlikely to overtake an economy plagued by high unemployment and meager wage gains.

A vocal minority of inflation hawks, however, are skeptical that the so-called output gap is a good determinant of US inflation. If the monetary authorities wait for the countrys 8.9 percent jobless rate to fall to more desirable levels, they say, it will already be too late.

Continued…

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