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Fed Unlikely to Hike Rates Despite Inflation Worries

Despite growing speculation that the Federal Reserve might raise interest rates to stem rising inflation, few expect a move anytime soon.

At most, analysts say, the Fed probably will stay in a holding pattern, with little incentive between now and the November presidential election to move rates either way.

Employment will be a critical factor in determining Fed behavior in the coming months, so the Labor Department's release next Friday of its monthly employment report will be closely watched.

"They're going to raise rates, but they want to see first the effect of the (economic) downturn on employment. That's going to be key for them," says Quincy Krosby, chief investment strategist at The Hartford. "They have got to wait to see that the consumer is able to pay bills and has jobs."

Analysts are expecting a moderate uptick in the unemployment number, probably to 5.1 percent from 5.0 percent last month, which is unlikely to move the Fed from its position of keeping rates low to mitigate the effects of the slowing economy.

"My sense is that between now and the end of the year they're just going to be looking at things and probably not making a move in either direction," says Bill Isaac, managing director at LECG of Vienna, Va., and former chairman of the Federal Deposit Insurance Corp. "They probably believe their work is done on the downside, and they'll step in when they're comfortable that the ship's been righted and we're starting to travel again."

That's not to say their isn't sentiment that the Fed should move rates higher. The lower interest rates were designed to increase liquidity in the financial markets, but they also have weakened the dollar and spurred a massive rally in commodities, particularly oil and grains. Gas prices have soared at the pump, and an economic index released Fridayshowed inflation to be chief among consumer concerns.

"I think they should put interest rates up and worry about inflation. What do I think they'll do? I think they'll delay," says Allan Meltzer, a professor of political economy at Carnegie Mellon and noted Fed watcher. "The Fed is spineless in response to pressures from Congress and pressures from Wall Street."

Lower interest rates weaken the dollar by increasing demand. Commodities like food and oil, meanwhile, are traded in those same weak dollars, which increases demand and drives prices higher.

"The Fed has made a mistake, in fact several of them, some of them serious," Meltzer says. "It clearly overreacted to the first quarter by cutting interest rates as much as it did, letting the dollar sink and letting inflation expectations increase. They put themselves into a much less favorable position than they should be in."

While not everyone agrees with that type of assessment -- many believe the Fed did all it could considering the troubles the economy and stock market faced -- a change in course would come largely as a surprise, despite comments this week from Fed governors that the bank may reverse policy.

In fact, the dollar rallied following the comments, and there was sentiment that the simple notion that rates would be raised was adequate to spur the US currency and drive down oil prices.

"For people to be calling now for the Fed to be hiking to me seems silly. Being on hold is prudent," says Tom Higgins, chief economist at Los Angeles-based Payden & Rygel. "I think that the Fed can and will remain on hold for a significant period of time. What people are underestimating at this state is that the lag effects of what happened in the credit markets this year are only going to be felt in the coming months. I think people are overestimating how strong the economy is at the current time."

And it's not just economists who doubt a Fed move. Investment advisers are in the same boat, but for somewhat different reasons.

"Once things start moving they'll bring rates back up again, but politically I don't see that happening before the election," says Randy Carver, president of Carver Financial Services. "But I don't think you'll see them cut rates either."

How to Invest Amid Inflation Fears

If inflation persists, the investor play is relatively simple: Go with the things that people will buy because they need them.

"Equities are supposed to fortify the investor against inflation on a long-term basis," Krosby says. "You go in where the companies can pass along the higher prices."

Specifically, Krosby likes leaders in consumer staples, health care and technology. She also points out that commodities are an obvious play against inflation, though she's inclined to wait for a significant pullback before getting back in.

Fixed income assets are also popular at times like these, especially if the Fed is going to stay put for a while.

Carver suggests high-dividend issues including the First Trust Active Dividend income fund and the Eaton Vance Tax-Managed diversified equity income fund.

Likewise, bonds could be appetizing for some, though Dennis J. Barba, managing partner of The Oxford Group, favors municipals at this point.

Barba points out that a change in interest rate policy should favor retirees and those who have their money in safer assets like certificates of deposit.

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