Economic Reports Muddle Fed Debate.

THE latest round of economic statistics showing that inflation pressures are intensifying is likely to complicate this week's Federal Reserve decision on whether to reduce interest rates.

The Fed's policy-setting Open Market Committee ought to cut rates again when it meets May 15, analysts say. The economy still is in the doldrums, and there's a serious risk of at least a mild recession,

"The downdraft in the economy is a greater burden to the Fed right now than any inflationary pressures," said Wall Street economist Henry Kaufman. He predicts the Fed will cut the overnight bank lending rate by up to half a percentage point.

Even so, the decision won't be easy. Inflation pressures, which were relatively benign only a few months ago, have surged to significant proportions, and are threatening to become a major problem unless they're checked sometime soon.

Consumer prices rose at a 4 percent annual rate between January and March. The gross domestic product deflator, the broadest measure of inflation, rose at a 3.2 percent pace in the first quarter. Energy prices are high and are expected to rise.

Worse yet, labor costs are mounting, and in the face of faltering productivity gains resulting partly from the slowdown, they're expected to crimp profits further and spur businesses to raise prices.

Declining productivity

Productivity actually declined at a 0.1 percent annual rate during the first quarter. Partly as a result, unit labor costs jumped at a 5.2 percent pace, the highest since the final months of 1997.

The new figures call into question Fed Chairman Alan Greenspan's insistence that the bulk of the past few years' improvement will remain once the slowdown is over. Some analysts say that if the Fed doesn't take inflation into account adequately, it will risk bringing on a period of stagflation, where the economy's growth is constrained by persistent inflation, as happened during the late 1970s.

The Fed has reduced its benchmark overnight lending rate by 2 percentage points since the beginning of the year. The rate now stands at 4.5 percent, the lowest in more than six years.

Fed policymakers have been feeling their way through uncharted waters. On April 18, they surprised investors by lowering the overnight rate by half a point a month ahead of the May 15 meeting. They're expected to order a similar cut this week.

Inflation contained?

As late as last month, Fed policymakers were insisting that inflation is essentially contained. Analysts say they can't make that claim indefinitely.

"If the Fed cuts interest rates by half a percentage point this time, it'll be a clear sign that it is making absolutely no pretenses about trying to control inflation," said Paul Kasriel, chief economist for the Northern Trust Co. in Chicago.

"It's the worst kind of situation that the Fed could have to deal with," Kasriel added. "If it presses down on the monetary accelerator, it'll be good for spurring more demand, but bad for inflation. No matter what it does, it can't win."

The Fed also may soon have to cope with enactment of President Bush's tax-cut package, which is expected to heighten any push the central bank gives the economy from interest rate reductions.

Assuming Congress passes the tax bill sometime in July, that means the stimulus would come in the last three months of 2001 and the first quarter of 2002, just when the interest-rate cuts that the Fed has engineered this year begin to have the most impact.

Not everyone views the inflation threat that starkly. This week's decision should be "a no-brainer for the Fed," said James Glassman, senior economist at J.P. Morgan Chase: Continue to cut rates for now.

"At some point, they'll say to themselves, 'We went fast, we went early, but this is the time to slow down.' But I don't think we're there yet," Glassman said. "With the labor market deteriorating, we're in a dicey situation."

Unfortunately for the Fed, the assessment of its current policies won't come until August or September, when it becomes clearer whether inflation or recession poses the biggest threat. Much may depend on how much the growth in productivity rebounds.

"Monetary policy is still playing catch-up," Kaufman asserted. "If the Fed delays in making further rate cuts this time around, it'll be taking on a significant risk." After May 15, the Fed's next interest-rate policy meeting is June 27.

Kasriel, however, is expecting productivity gains to remain meager in coming months. "Inflation is rising faster than the real economy is growing," he said. "If you don't want to call that stagflation, I would call it the beginning of stagflation."

It's not an easy spot for the central bank.

Art Pine is a columnist for Bloomberg News.