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NEW YORK (CNN/Money) -
Let's dispense with the obvious.
The Federal Reserve will raise the fed funds rate, a short-term rate banks use to determine what they charge for loans, on Tuesday by a quarter of a percentage point in order to help combat inflation. Such a move would be the eighth hike since last June and would bring interest rates up to 3 percent.
There is little doubt that this is going to happen. According to fed funds future contracts listed on the Chicago Board of Trade, traders are pricing in a 95 percent chance of a quarter-point hike and a 5 percent probability of a half-point hike.
But what will happen after that? Suddenly, investors have begun to worry more about a slowing economy, leading to a debate about how many more rate hikes are in the cards.
Uninspiring first quarter earnings reports from IBM and GM, a slump in housing starts and weak retail sales in March, and lower than expected first-quarter gross domestic product growth (GDP) have investors on edge.
Yet, inflation fears haven't subsided either. Oil prices may have retreated from early April's record highs but are still near $50 a barrel. The cost of consumer goods rose at a higher than anticipated rate in March and the Fed's favorite inflation indicator, another measure of consumer prices that was part of Thursday's GDP report, also indicated stronger pricing pressures.
These somewhat conflicting trends have led some economists and market observers to worry that the economy could be headed for a period of stagflation, an environment characterized by sluggish growth and soaring prices.
The conundrum returns
With all this in mind, the market will closely scrutinize how the Fed describes the state of the economy in the statement it issues after Tuesday's meeting...and what those words will mean about the future direction of interest rates.
"What the Fed says is more important than what they do," said David Kelly, economic advisor with Putnam Investments, a money management firm based in Boston.
With the economy showing signs of weakness, investors are hoping that the Fed will not need to raise rates much higher, for fear that more rate hikes could further dampen growth.
But Kathleen Gaffney, portfolio manager with the fixed income group of Loomis Sayles, an institutional investment firm based in Boston, said she expects the Fed will continue to cite inflation as a key concern, despite the increased evidence of an economic slowdown, in order to signal that more interest rate hikes are on the way.
The yield on the 10-year Treasury has plunged about 40 basis points since the Fed's last meeting and, at 4.19 percent, is back near mid-February levels. At that time, Fed chairman Alan Greenspan issued his now infamous remark to Congress that low long-term rates, despite the Fed's hikes, were a "conundrum."
Bond prices and yields move in opposite directions so the sudden drop in yields indicates heavy investor interest in fixed-income securities. And Gaffney said that the Fed still would like to see long-term rates move higher in order to help shake out excess liquidity in the bond markets, and to a lesser extent, high real estate prices. Longer-term Treasury yields have a big impact on mortgage rates.
"Inflation fears, to me, are provoked by the Fed to get the market to do some of its work for them," said Gaffney.
To measure or not to measure? That is the question.
Mark Zandi, chief economist with research firm Economy.com, agrees that the Fed would like to see long-term rates move higher. Although he doubts the Fed will actually do so, he thinks the Fed should eliminate the "measured" language it has used to describe its pace of rate hikes since it began raising rates last year.
"Reintroducing a little uncertainty in the bond market would be desirable. Long-term rates are too low," Zandi said.
But the Fed has taken great pains not to spook Wall Street during the past few years, painfully telegraphing all of its moves in advance. As such, Kelly said it would be a mistake for the Fed to get rid of "measured" from its statement.
"What the Fed should do is stick to the message. If it ain't broke, don't fix it," Kelly said. "The economy is basically healthy."
But Zandi argues that in light of recent economic data, it's no longer clear what the Fed should do at its next meeting in late June. So eliminating the "measured" term would clearly signal to the market that the Fed has to keep all its options open.
"A month ago the markets would have interpreted getting rid of measured as meaning that a 50 basis point hike was possible. Now the market won't know if it would mean no change, another quarter-point move, or a 50 point hike is next and that's precisely why the Fed should take it out," Zandi said.
Still, regardless of what the Fed says, there is a growing sense that it has inflation under control. So the question is whether or not the slight dip in the economy is a worrisome sign. Keith Hembre, economist with First American Funds, a mutual fund firm based in Minneapolis, doesn't think that's the case.
"Growth should decelerate through the final three quarters of the year and once that happens inflation pressures we've seen will begin to ease. That should lead to a more benign tightening cycle, which won't be threatening to the financial markets," said Hembre.
In other words, the Fed will probably keep raising rates at a measured pace even if it doesn't explicitly say it will. Gaffney, for example, thinks the fed funds rate will be no higher than 4 percent at the end of the year, which implies four more quarter-point hikes after Tuesday's meeting.
But the economic X-factor, of course, is oil. Many economists pointed to energy prices as a primary reason for the weak GDP number in the first quarter. If oil continues to be a drag on the overall economy, the Fed could have its hands tied.
"Oil is a double-edged sword. From one aspect, it lifts overall inflation but from the other side of the same coin it places a constraint on growth. So if oil prices remain high, the implications for the Fed get a little dicey," said Hembre.
Who might succeed Alan Greenspan as Fed chairman? Click here for more.
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