Will Fed Opt to Reset Economic Thermostat?

Like Goldilocks picking the right porridge, America's central bankers have the delicate job of choosing whether the economy is:

A) Overheated.

B) Not hot enough.

C) Or just right.

It's an extremely close call. When the Federal Reserve's policymakers meet tomorrow to decide whether to raise interest rates, they'll have to sift through economic data that paint a confusing picture of continued strength and growing weakness. Their decision will determine whether Americans will have to spend more on everything from financing a new home to borrowing to start a business.

While not growing as quickly as in past recoveries, the nation's economy has been expanding now for 5-1/2 years, a long run by historical standards. The balance is delicate. If the central bankers miss, they could rattle Wall Street and push the economy into more rapid inflation or cause a recession. And in an election year, a change in interest rates takes on even greater relevance.

"Both the stock market and the Fed are walking a very tight rope," says Alan Ackerman, senior vice president of investment at Fahnestock & Co. in New York. "My guess is that the Fed would prefer not to raise [interest rates] at this point. [But] the Fed may have no choice."

Market sentiment about what the Federal Reserve will do has shifted several times in the past few weeks. In a highly unusual lapse for the normally tight-lipped Fed, a wire-service report last week quoted a "senior Fed official" as saying that a consensus was forming for a quarter-point increase in the Federal Funds target rate, the rate banks charge each other on overnight loans. A rise in that rate would boost other interest charges, making it more expensive to borrow money and slowing the economy.

But does the economy really need to be slowed? The data are mixed.

Take inflation. So far this year, the prices Americans pay for goods and services have risen faster than in the same period for any of the past five years. That would suggest the economy is speeding up.

But the core rate of inflation, which excludes the volatile prices of food and energy, has actually been lower during the same period than in any of the past five years. That would signal a slowing economy. Which is true?

"There's food for thought for every appetite," says Robert A. Brusca, chief economist with Nikko Securities International in New York.

Another data puzzle

The latest statistics show exports are down, usually a sign of weakness. But industrial production last month jumped a surprising 0.5 percent, a sign of strength. Unemployment is down to its lowest level in seven years, but wages so far haven't gone up.

"The Fed faces an interesting challenge," says George Perry, an economist at the Brookings Institution, a Washington think tank. "They've allowed the economy to grow a lot more than most economists would have advised a few years ago. The Fed deserves a lot of credit for that."

Now, with little room in the economy to maneuver, "a small increase in rates, just to prove that we are paying attention, is probably a good idea," Mr. Perry adds.

The balance between unemployment and inflation is key. When the economy grows, unemployment falls. At some point, unemployment gets so low and workers have so many job options that they begin to demand bigger raises in pay. That can cause inflation.

How low can jobless rate go?

Because there are always some workers between jobs, the economy always has some unemployment. Most economists have long thought that when the unemployment rate dropped below 6 percent, it would trigger more rapid inflation.

But with joblessness down to 5.1 percent and no sign of big pay raises, some economists theorize the nonaccelerating rate may be far lower.

They suggest the Federal Reserve should let the economy grow faster so policymakers can find out how low unemployment can fall before triggering more inflation.

But most economists don't want to take that risk.

"We're on thin ice; we hear the ice cracking," says Mr. Brusca of Nikko Securities. "People say: 'Hey, you can take another step.' And maybe you can, but what are you gaining? ... Maybe you get so far out there before the ice cracks that you can't get back."

Brusca and some other economists suggest the safer move is to take a small step back, hike interest rates by a quarter percentage point, and wait to see if the temperature changes.