IMPEACH BUSH

July 29 (Bloomberg) -- The policy debate within the Federal Reserve is growing sharper.

On one side is Fed Chairman Ben S. Bernanke, who is opposed to raising interest rates even though consumer prices have gone up 5 percent over the past year.

On the other are at least three of the nine voting members of the Federal Open Market Committee. They want a rate increase to make sure prices come down and to reinforce the Fed's inflation-fighting credibility.

The outcome of the debate at the group's Aug. 5 policy- making session probably isn't in much doubt really: A majority is sure to back Bernanke, with the FOMC's target for the overnight lending rate being left at 2 percent.

The crux of the disagreement is whether the 325-basis-point reduction in the target since last September will stimulate growth enough to add to inflation pressures. After all, at 2 percent, the target is well below the inflation rate -- a condition normally regarded as very stimulative for the economy.

But these are hardly normal times.

The FOMC members sharing Bernanke's view believe the turmoil in financial markets has made it much harder for many households and businesses to get credit. As a result, the negative real federal-funds rate -- as the target is known -- isn't giving the economy as much of a boost as it usually would, they say.

For instance, some key interest rates, such as those on 30- year fixed-rate home mortgages, are little changed in the past year even after the big drop in the Fed's target. Rates on so- called jumbo loans -- those too big to be used as collateral for mortgage-backed securities carrying a federal guarantee -- are a full percentage point or more above their year-earlier levels.

Tighter Credit

Many lenders have tightened other terms on loans as well. Lines of credit have been cut and the level of banks' commercial and industrial loans outstanding are shrinking. Home-equity loans are harder to get, though the amount of such loans is still increasing slowly.

Only large, highly rated corporations are able to borrow on favorable terms and relatively low interest rates, and even those have increased lately.

On the other hand, the economy is growing -- probably at about a 2.5 percent annual rate in the second quarter -- and Fed officials expect it to continue to do so in a subdued way even with tight credit. With inflation as high as it is, even those who don't want to raise rates now have some sympathy with the arguments of those who do.

Inflation Hawks

Richard W. Fisher, president of the Dallas Federal Reserve Bank, dissented in favor of a quarter-percentage point increase in the lending rate target at the June 24-25 FOMC meeting because businesses were becoming more willing to increase prices to protect their profit margins, according to minutes of the meeting.

Gary Stern, Fisher's counterpart at the Minneapolis Fed, said in a July 26 Bloomberg interview, ``We can't wait until we clearly observe the financial markets at normal, the economy growing robustly, and so on and so forth, before we reverse course.''

And Charles I. Plosser, president of the Philadelphia Fed, is among the more optimistic FOMC members in terms of the outlook for growth and is very concerned about what that may mean for inflation.

``Keeping policy too accommodative for too long worsens our inflation problem,'' Plosser said in a July 22 speech, adding that interest rates will need to be raised ``sooner rather than later.''

Holding Down Expectations

Plosser said he expects gross domestic product to grow about 2.75 percent in 2009, with the inflation rate falling as energy and other commodity prices level off, ``provided we set monetary policy appropriately to restrain inflation and keep inflation expectations well-anchored.''

Almost all Fed officials agree that keeping public expectations of future inflation low is an important element of holding down actual inflation. If businesses expect higher inflation, they would be more likely to increase the prices of the goods and services they sell, and their employees would be more likely to demand higher pay, or so the argument goes.

Inflation expectations for several years ahead are hard to measure, and those are the ones many economists say are the most important. One source is the Reuters/University of Michigan consumer sentiment survey, which had shown for several years that consumers expected inflation of about 3 percent over the next five years.

Oil Prices Ease

However, this spring the figure moved up to 3.4 percent in May and June before dipping to 3.2 percent this month.

It's a tough time to be a Fed official.

The economy isn't doing well. Inflation is too high, though oil prices are off their record high and some other commodity prices, such as corn, have weakened as well.

Financial markets remain fragile and credit is tight. Still, there are signs that the housing sector is hitting bottom.

So what's a good policy maker to do? Sitting tight on Aug. 5 is probably the best answer at this point.

Otherwise investors might assume an increase was just the first of several, which may be more than the economy could stand.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net
Last Updated: July 29, 2008 03:32 EDT