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Surging Oil Prices Put Fed In a Bind on Interest Rates

The unrelenting rise in oil prices has put U.S. Federal Reserve Chairman Ben Bernanke in the precarious position of trying to talk down inflation without raising interest rates.

The result may be a blow to the central bank's credibility, just as Bernanke was finally winning plaudits from many on Wall Street for his handling of the credit crisis.

"They've painted themselves into a corner," said Gabriel Stein, an economist at Lombard Street Research in London. "I think the Fed is losing credibility by the buckets right now."

The Fed is expected to keep its benchmark federal funds rate unchanged at 2 percent when its policy-setting committee meets this week.

It has more than halved rates since mid-September in a bid to prevent the housing slide and credit contraction from triggering a deep recession. But as the U.S. economy weakened in recent months and rates fell, the dollar's slump deepened.

That has contributed to rising prices for oil and other commodities that are priced in dollars, and has also made imports more expensive.

Overall inflation rose by an uncomfortably high 4.2 percent year-over-year in May, which under normal circumstances might have encouraged the Fed to raise rates.

The trouble is, the economy remains fragile, as evidenced by the persistent rise in unemployment, the still-weakening housing market, and a slowdown in manufacturing.

And it is not just a U.S. problem. Inflation is running at the highest level in more than a decade in China and India.

Mexico's central bank raised borrowing costs for the first time in eight months Friday to tackle inflation stemming primarily from soaring food prices.

"The dilemma now faced by the (Fed's monetary policy) committee is that while the economy has not collapsed, it is not exactly providing signs of an imminent recovery," said Joseph Brusuelas, chief economist with Palo Alto, California-based Merk Investments. The Fed "is caught in between what it should do—raise rates—and what it needs to do, remain on hold."

In a speech earlier this month, Bernanke tried to tackle price pressures another way, by raising concerns about the inflationary impact of the falling dollar.

That caught investors' attention because it is unusual for the Fed chairman to talk about currency matters, which are normally the purview of the Treasury secretary.

While Bernanke's comments sent the dollar higher and cooled the oil rally, markets reversed course just days later when Bernanke's European Central Bank counterpart, Jean-Claude Trichet, said an ECB rate hike could come as early as July.

That prompted some investors to speculate that there may be a rift between the two central banks, although sources on both sides of the Atlantic dismissed that idea.

Still, whether there is bad blood or not, the gap between U.S. and euro zone interest rates looks likely to widen further, and that could put more pressure on the dollar—and provide more fuel to the oil market.

If the ECB raises its rate by one-quarter of a percentage next month as expected, it would stand at 4.25 percent, more than double the federal funds rate.

That would encourage currency traders to dump dollars in favor of higher yielding euros.

Complicating matters for both Bernanke and Trichet is the fact that much of the inflation pressure is coming from beyond their borders.

Emerging markets accounted for more than 50 percent of oil consumption last year, up from 30 percent in the 1960s, according to JPMorgan research.

As oil prices surged above $130 per barrel, pushing U.S. gasoline costs to the psychologically significant $4 per gallon, U.S. consumers have cut back on driving and sought more fuel-efficient ways of doing business.

Emerging markets have been slower to curb their usage, but that looks set to change.

JPMorgan predicted that global oil demand would fall this year for the first time since 1993.

Just last week, China increased retail gasoline and diesel prices by as much as 18 percent, which may help cool demand.

But with world oil supplies tight, it still may not be enough to bring U.S. cost pressures back down to the Fed's comfort level, leaving Bernanke in a stagflation bind should the economy keep slowing while price pressures persist.

If inflation remains stubbornly high, Bernanke may have to do more than just talk about it, a strategy that Lombard's Stein dubbed, "speak loudly and carry a twig." Stein said Bernanke had already done damage to the Fed's inflation-fighting credibility in recent weeks when he and other Fed officials talked tough -- only to retreat when markets got carried away and priced in a series of rate hikes.

"When Trichet says 'We're going to raise rates,' markets say 'We believe you.' When Bernanke says 'We're going to raise rates,' markets say, 'Why should we believe you?"' Stein said.

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