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Fed keeps up its balancing act.

The Federal Reserve left interest rates at 5.25% for its third straight meeting last Wednesday. The pauses have been indicative of the wait-and-see approach that the Fed has taken in dealing with the two major economic indicators that determine its actions on monetary policy; GDP growth and inflation.

Policy geared towards bolstering the health of either one can come at the expense of the other and balancing the two in recent months has become an increasingly tenuous job for the Fed given the slowdown in the nation's housing market and the lingering economic impact of record energy prices.

While inflation is only slightly above the Fed's comfort zone of between 1-2%, the consensus among economists is that it remains threatening enough to curtail a slackening in rates. The Fed has been wary to combat inflation with further rate rises in recent months because it doesn't want to further crimp economic growth, which has slowed from a brisk 5% in the first quarter to 2.6%.

Before its meeting in August, the Fed had raised rates by a quarter point for 17 consecutive meetings, a two-year series of rises that brought interest from a historical low of 1%.

Milton Ezrati, an economist at Lord Abbett, stated that the nation's gradually cooling residential real estate market will have a minimal impact on the economy because of low unemployment rates and steady wage increases. Consumer spending, which accounts for two thirds of the nation's economic activity, has been fuelled in recent years by the cash many homeowners have drawn against their homes, loans that became increasingly popular during the dramatic appreciation of the residential real estate market in recent years.

There had been concern among economists and the Fed's board members that if home prices leveled off or even worse, plummeted as a result of a housing bubble, consumer spending would dip.

"The fact is, it's wages and employment that really drive spending," Ezrati said. "Economic growth is robust enough to sustain itself through what's going on in the residential markets right now."

Inflation has been of greater concern to the Fed and was addressed in two of the four paragraphs in its statement last Wednesday, a document whose language and content is closely scrutinized by analysts for subtle hints on future monetary policy.

Because of the seeming primacy of inflation over concerns for slowed economic growth, many economists concluded that a rate hike in the next few months is far more likely than a cut.

Indeed the futures market for bonds has priced in the expectation of a modest rate rise.

"... The Committee judges that some inflation risks remain," the Fed's statement read.

"The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

The Fed stated that dropping energy costs would likely help moderate inflationary pressures however.

Gary Gabriel, an investment sales broker for commercial property for Cushman & Wakefield in New Jersey, said that the threat to consumer spending from the current drooping real estate market is ratcheted up significantly by the prospect of the Fed having to use interest rate hikes to curb inflation. Homeowners may not borrow as much money against their homes when values drop he said, but their spending would take an even worse turn if they had to pay steep interest rates on the money they already owe.

"That could be one of those impossible situations for the Fed," Gabriel said. "If they have to raise rates to combat inflation and that winds up hurting consumer spending, that's a bad situation."
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Author:Geiger, Daniel
Publication:Real Estate Weekly
Date:Nov 1, 2006
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