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Economic Outlook: Why Is the Fed Worried About Inflation?

Manufacturing is tanking. So is construction spending. As investors head for the exits, more analysts start talking about the need for lower interest rates to jump-start the economy.

So what do Federal Reserve officials focus on during their public appearances on Friday? Inflation and the possiblity that interest rates may have to go up to keep it in check.

What's going on here?

It's an old adage in the markets that you don't fight the Fed. But many experts are wondering what the central bank is seeing that they don't.

"I think one of things that spooked the market was a one-two punch," CNBC's Senior Economics Correspondent Steve Liesman said on Friday's "Closing Bell."

"Not only did you have negative economic news but two Federal Reserve Bank presidents come on and say we don't really care...The stock market, at least, is left with the impression, wait a second, maybe the Fed is about to go too far again."

Liesman will get the chance to press a top Fed official on this question Monday morning when he interviews Chicago Fed President Michael Moskow live on cnbc.com. The interview will start at 9 am New York time.

Shocking the Market

Moskow shocked many market-watchers on Friday by not only taking an optimistic view of the economy but actually calling for further rate increases to control inflationary pressures.

"Some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time," Moskow told the Carthage Business and Professional Coalition.

Moskow won't be a voting member on rates until next year, but his views are seen as an important indicator of where the Fed's thinking is right now.

Economists--and the markets--were surprised Friday morning when a key manufacturing survey showed that the sector is actually contracting.

The barometer of business activity, which is put out by the Institute of Supply Management, fell to 49.5 in November. This index, which has been falling steadily for five months, punctuated a week of mostly weaker economic data.

“The data this (past) week were weaker than the market was expecting, particularly the ISM report,” said Mickey Levy, an economist at Bank of America. “Consumer confidence was down, and the durable goods report pointed to lower levels of capital spending.”

Predicting a Rate Cut

With the gauge of manufacturing activity below 50, which signals a contraction, some analysts say a rate cut is inevitable.

Merrill Lynch economist David Rosenberg said the Fed has always cut rates, usually within two to three months, whenever a contraction in manufacturing is seen.

"Manufacturing has joined construction in recession," Rosenberg said. "In other words, almost 20% of the economy is now contracting."

But so far, the Fed seems to be more worried about inflation than the slowing economy. That was clearly the message sent last week. Even Fed Chairman Ben Bernanke said in a speech on Tuesday that the risks of inflation "seem primarily to the upside."

"Given the current level of inflation, a failure of inflation to moderate as expected would be especially troublesome," he said.

Jobless Report on Friday

Besides Moskow's comments on Monday, investors will be closely watching this Friday's unemployment report for fresh clues about the health of the economy.

Bank of America’s Levy is forecasting nonfarm payrolls to fall to 80,000 in November from 92,000 in October. Levy’s estimate is on the low-end of expectations.

Last month, nonfarm payrolls were weaker than economists had predicted, but prior months were revised sharply higher and the unemployment rate fell to 4.4% from 4.6%.

Investors will also be paying close attention to the ISM non-manufacturing survey on Tuesday. That could help determine whether the slowdown in factory activity is spilling over into the service sector.

Last week’s Fed Beige Book indicated the demand for services remained healthy. The sector posted a surprisingly strong performance in October, with the non-manufacturing index rising to 57.1 from 52.9 in September.

Also on Monday, pending home sales data will be released at 10 am New York Time. This data, which measures the number of contracts signed by sellers of existing homes, is often subject to wide revisions, but it can provide fresh insight on the pace of existing home sales.