As Oil Muddies Outlook, Fed Policy Less Certain

Surging oil prices are deepening a split inside the Federal Reserve, blurring the likely direction of monetary policy and making next week's 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 Fed's March 15 gathering.

"The meeting has definitely gotten more interesting for the participants than they'd 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. That's 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 economy's 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 U.S. inflation. If the monetary authorities wait for the country's 8.9% jobless rate to fall to more desirable levels, they say, it will already be too late.

This camp points to the Fed's massive expansion of credit to the banking system, including zero interest rates and $2.3 trillion in government and mortgage bond purchases to prop up credit markets hit by the worst financial crisis in generations.

The purchases have more than tripled the central bank's balance sheet and Philadelphia Fed President Charles Plosser calls it the "kindling" of future inflation.

In next Tuesday's policy statement, the Fed will likely manage this dissonance by acknowledging a recent pick up in energy costs but also reiterate that inflation expectations remain well anchored.

At this point, most analysts see the Fed completing its current $600 billion bond purchase program and calling it a day, even if the situation in the Middle East has widened the range of possible outcomes.

THE PSYCHOLOGY OF ECONOMICS

Unlike the European Central Bank, which recently hinted it could raise rates as early as next month, few believe Fed tightening is imminent.

"We still assume no interest rate hike until 2012," said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts. "The Fed is not the ECB. It will not raise interest rates just because headline inflation is rising."

Indeed, Fed officials have taken pains to point out that, while deflation no longer appears to be a risk, underlying or core inflation remains around 1 percent -- well below the Fed's presumed target of 2 percent or a bit below.

With U.S. crude oil prices up around $105 a barrel and domestic gasoline costs moving up quickly as a result, it is not hard to envision a scenario where fears of inflation turn into more entrenched expectations for higher prices.

Policymakers across the hawk-dove spectrum see expectations as a key harbinger of future inflation and this might force the Fed to tighten the monetary purse strings even with the economy still struggling to gain traction after the recession.

Speeches from two of the Fed's regional presidents on Monday highlighted the internal discord. Richard Fisher, the Dallas Fed's colorful hawkish president who likes to quip that doves are "part of the pigeon family," said he was starting to seriously consider dissenting against continued accommodation.

In contrast, Atlanta Fed President Dennis Lockhart raised the possibility that the Fed would have to extend a $600 billion bond-purchase program beyond its June deadline if a further spike in oil appeared to threaten the recovery.

"My sense of the balance of risks has shifted with the addition of unrest in the Middle East and North Africa," Lockhart said.

Given that Lockhart's thinking has tended to mirror that of the Fed's power nucleus in Washington, it is probably a safe bet to expect the Fed to remain on hold for a while -- even if futures markets are pricing in some year-end tightening.