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The Fed's tightrope act

The banking industry is in a quagmire. But the economy isn't in dire shape and inflation remains an issue. What are Ben Bernanke and the central bank to do?

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By Paul R. La Monica, CNNMoney.com editor at large

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NEW YORK (CNNMoney.com) -- The financial services industry is reeling due to exposure to bad subprime mortgage loans. The Federal Reserve has cut interest rates three times in a row and Wall Street is crying out for more.

But some experts suggest that the Federal Reserve may not cut interest rates much further in 2008 because the rest of the economy remains in relatively decent shape and inflation is still a concern.

On Friday, the government reported that the Consumer Price Index, which measures retail prices, rose 0.8 percent, higher than the 0.6 percent increase economists were expecting. Excluding the impact of energy and food prices, the so-called core CPI increased 0.3 percent, slightly ahead of the 0.2 percent increase forecast by economists.

The bigger-than-expected rise in the CPI came on the heels of another government report Thursday that showed the Producer Price Index, which measures wholesale prices, rose 3.2 percent, the biggest jump in 34 years. To be sure, much of this increase was due to soaring oil prices.

But the core PPI number rose 0.4 percent, above Wall Street's expectations of just a 0.2 percent increase.

The two inflation reports are beginning to dampen hopes of a rate cut at the Fed's next meeting, a two day session that concludes on Jan. 30.

According to futures trading on the Chicago Board of Trade, investors are pricing in an 84 percent chance that the Fed will cut its federal funds rate by a quarter-point, to 4 percent. Earlier this week, the market was pricing in a 100 percent chance of a rate cut.

Stocks slipped at the opening bell Friday morning after a mixed day Thursday.

What's more, despite all the doom and gloom about the housing market, the Commerce Department reported Thursday that retail sales surged 1.2 percent in November. And even if you exclude sales at gas stations, which were obviously juiced by rising prices at the pump, sales were still up a healthy 0.6 percent.

Add this up and the Fed's two big announcements this week suddenly seem to make a lot more sense.

"It's clear that the economy's moderation in recent months has been relatively gentle. There has been no outright collapse," said David Resler, chief economist with Nomura Securities International. "The economy may be on the soft side, but that doesn't mean we're going into a recession."

The Federal Reserve cut two key interest rates by only a quarter of a percentage point Tuesday, a move that caused Wall Street to panic. The Dow plunged nearly 300 points.

Many investors were hoping for a half-point cut, or at the very least, a half-point cut to the discount rate, which is what it costs banks to borrow directly from the Fed. But Wednesday, Ben Bernanke & Co. saved face somewhat by announcing a plan to inject billions of dollars into the banking system.

In conjunction with several other central banks in Canada and Europe, the Fed said it would conduct four auctions in the next month that will allow banks to bid for loans. Sources said it will probably cost banks less than the 4.75 percent discount rate to borrow money this way.

The combination of a mild rate cut and the new auction system seems to indicate that the Fed is looking for a creative way to solve the credit crunch on Wall Street rather than by simply slashing interest rates.

And considering the inflation and retail sales numbers released Thursday, some experts said the Fed would be wise to stick to this strategy.

"With higher inflation than expected and strong retail sales, it's hard to justify aggressive easing," said David Wyss, chief economist with Standard & Poor's. "I'm sure they are glad they did a quarter-point cut and not a half-point cut."

Another market strategist said that Wall Street is starting to realize that the economy may not be on the verge of a recession.

To that end, weekly jobless claims were lower than expected as well.

"The consumer is clearly not dead yet," said Quincy Krosby, chief investment strategist with The Hartford.

But the Fed is in a tough spot since the financial markets clearly want the central bank to be proactive in order to make sure the liquidity crisis doesn't spill over into the broader economy and cause a recession. Still, there's little to suggest as of yet that this is actually happening.

"Going into Tuesday, if you just looked at what's going on in the financial markets, you would have cut by 50 basis points [a half percentage point]. But if you look at just the economic data, you would have done nothing," said Steve Van Order, fixed income strategist with Calvert Asset Management Co., a Bethesda, Md.-based investment firm with $16.1 billion in assets under management.

Van Order hailed Wednesday's auction plan as a "smart and creative" move by central banks, and said that this could help the Fed address credit concerns without having to cut rates sharply, which it clearly does not want to do.

"The Fed might feel a little closed in by economic data that isn't too bad and inflation numbers that are showing higher commodity prices. The market was trying to twist the Fed's arm," Van Order said. "But by addressing the liquidity crunch it won't have to cut the fed funds rates that aggressively. It may look to do so more cautiously."

Still, some wonder if the Fed's continued focus on inflation is misguided.

Matthew Smith, president and chief investment officer with Smith Affiliated Capital, a fixed-income investment firm in New York with $1.8 billion in assets under management, points out that growth in the core PPI over the past 12 months is only 2 percent. The Fed is widely believed to be comfortable with inflation within a 1 to 2 percent range.

"The Fed does not need to be concerned about inflation," Smith said. "The Fed made a mistake by only cutting by quarter of a point. By continuing to just cut by a quarter-point, it's prolonging the inevitable and is behind the curve in terms of solving the credit problem."

Nomura's Resler also said that inflation is not a major issue. Before Friday's CPI report, he predicted that retail prices could be higher than expected but that the increase would not be so significant that it would keep the Fed from cutting rates in January.

Nonetheless, it's starting to look like the Fed will probably continue to take a relatively measured, to use a favorite word of Fed statements past, approach to interest rate cuts at its next meeting and beyond.

"The Fed doesn't feel big rate cuts are necessary. This is a financial markets and housing problem, but so far, it's a minor problem for the overall economy," Standard & Poor's Wyss said.

The Hartford's Krosby added that employment figures will be key. If the December jobs report, which will be released in early January, is weaker than forecast, the Fed may move to cut rates by more than a quarter-point.

"The Fed is very data dependent right now," she said. "If unemployment creeps higher, you'll see the Fed lowering rates more aggressively."  To top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.