Fed keeps rates low so recovery won't slow

Storm warnings?

In fact, some recent significant circumstances have likely heightened the Fed's concerns. Most notably, gas prices are soaring, putting an already-weak recovery further at risk.

"The Fed is very concerned about oil at $112 a barrel," says Greg McBride, CFA, Bankrate's senior financial analyst. "It's given them more ammunition for this wait-and-see attitude with regard to the economy."

Energy prices aren't the only fly in the economic ointment. The raging debate in Washington, D.C., over the federal budget deficit and whether Congress should raise the debt ceiling could potentially derail any progress the economy has made coming out of the recession, Gramley says.

"There are two choices if the debt ceiling is not raised," he says. "One is to default on debt, which would have an enormously negative effect on interest rates through the foreseeable future, for the next 30 years or so."

The other alternative is avert default by rapidly cutting government spending until it falls below federal revenue. The problem: "You (would) have to cut expenditures by $100 billion a month, or an annual rate of $1.2 trillion," Gramley says. That's roughly 8 percent of U.S. gross domestic product. "Go on with that for several months and we will see the biggest decline of economic activity in this country that we've seen since 1929," he says.

A Congressional vote on raising the debt ceiling is expected in the next couple of months.

A wave of inflation?

If the Fed has some breathing room, it's that so-called core inflation -- stripped of volatile energy and food prices -- remains quite low. It's up 1.2 percent over the last 12 months, according to the latest figures from the Bureau of Labor Statistics.

The difficulty will be if soaring prices of oil and other commodities -- corn has doubled in the last year -- begin pushing up prices across the economy, says Jeremy Siegel, the Russell E. Palmer Professor of Finance at the Wharton School at the University of Pennsylvania.

"Bernanke may be forced to raise interest rates as soon as this summer" if core inflation starts to spiral upward, Siegel says. Historically, raising interest rates has been one of the Fed's most powerful tools to fight inflation.

Janet Yellen, Federal Reserve vice chair and an FOMC voting member, said in a speech earlier this month that inflation isn't an immediate threat, however. In Fed parlance, Yellen is generally considered an inflation "dove," meaning she favors the current easy-money policies and considers inflation a relatively minimal concern.

"Increases in energy and food prices are, without doubt, creating significant hardships for many people, both here in the United States and abroad," she told the Economic Club of New York. However, she added that "empirical analysis suggests that these developments, at least thus far, are unlikely to have persistent effects on consumer inflation or to derail the recovery."

Yellen's views were echoed by the FOMC's statement Wednesday. "Inflation has picked up in recent months, but longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued," the FOMC statement said.

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