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It also signals pause in rate cuts, fearing impact on value of greenback

WASHINGTON - THE United States Federal Reserve’s warning about possible higher inflation and a weaker American economy sparked fears that the country faces stagflation.
 
In minutes released on Wednesday, the US central bank broke its traditional silence to highlight the danger of a slide in the value of the US dollar.

It also slashed its economic growth forecast for this year and signalled that mounting concerns over inflation would make further interest-rate cuts unlikely.

In the minutes, the Fed revealed increasing discomfort at the US dollar’s impact on import prices, with one official also blaming interest-rate cuts for sapping the greenback’s value and contributing to a climate that further impairs economic growth.

This followed a noticeable increase in dollar remarks from Fed officials, including vice-chairman Donald Kohn - trespassing on the turf of the US Treasury, which by long agreement acts as the country’s spokesman on foreign exchange.

The dollar had hit record lows against the euro and other major currencies as the Fed slashed interest rates to shield the world’s largest economy from the US sub-prime mortgage market meltdown.

The US Treasury has shown no inclination to bow to foreign pressure to do something about its sickly currency, beyond doggedly repeating the mantra that a strong dollar is in the country’s interest, and that strong long-term fundamentals of the American economy will be reflected in exchange rates.

Mr Kohn’s remarks on Tuesday seemed innocuous. He observed that a weaker dollar boosts US exports while potentially fuelling imported inflation - a statement of accepted economic wisdom.

But policymakers of Mr Kohn’s stature do not make accidental references to the dollar in carefully crafted speeches, and it was not an isolated incident.

Fed officials debating whether to cut interest rates at their last policy meeting were worried that a weak dollar was adding to inflation pressures by making imports into the country more expensive, minutes of the meeting showed.

‘Many participants - noticeably more than in January - saw the upside risks to inflation as greater than the downside risks,’ the minutes of the April 29-30 meeting said.

‘In particular, the pass-through of recent increases in energy and commodity prices as well as of past dollar depreciation to consumer prices could be greater than expected.’

Dallas Federal Reserve bank president Richard Fisher, who opposed the most recent rate cut, was concerned that an ‘adverse feedback loop’ was developing. He feared that lowering the funds rate would push down the exchange value of the dollar, contribute to higher commodity and import prices, cut real spending by businesses and households and, ultimately, impair economic activity, the minutes said.

The minutes were released shortly after Fed governor Kevin Warsh said that central bankers could not ignore the plight of the currency.

Fed officials also said in the minutes that cutting benchmark interbank lending rates by a quarter percentage point to 2 per cent at their last meeting was ‘a close call’.

‘If you had any doubt that the Fed is signalling a pause, that doubt is gone,’ said Mr Christopher Low, the chief economist at FTN Financial.

In an accompanying forecast, the Fed cut its projection for US growth this year to a scant 0.3 per cent to 1.2 per cent, down from the 1.3 per cent to 2 per cent it had forecast three months ago.

US stocks tumbled on Wednesday after the Fed forecast, with the Dow Jones Industrial Average closing off nearly 1.8 per cent.

REUTERS
 
Source : Straits Times - 23 May 2008