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Fed may open door to higher interest rates

Fed may open door to higher interest rates

With unemployment tumbling, the Federal Reserve this week is expected to set the stage for its first interest rate hike since 2006 despite concerns about meager wage growth and inflation. “They will look through the weakness,” says Jim O’Sullivan, chief U.S. economist at High Frequency Economics.janet-yellen-hearing2

After a two-day meeting ends Wednesday, the Fed is expected to remove from its statement an assurance to “be patient” as it considers an initial bump in its near-zero benchmark rate. Based on recent Fed guidance, that step is necessary to leave the central bank the option of raising the rate as early as June. Many economists and Fed policymakers are forecasting an initial June hike.

Such a move could be controversial because the Fed is caught between conflicting economic forces. Job growth hit a 15-year high in 2014 and February’s 5.5% unemployment rate — down from 10% in October 2009 — is already close to the Fed’s desired range. Normally, low unemployment puts upward pressure on wages and inflation as employers compete for fewer available workers.

But wage growth is still feeble. And inflation remains well below the Fed’s target, largely because of low oil prices and a strong dollar that’s making imports cheap for U.S. consumers. That worries some Fed officials because it leaves the economy vulnerable to a shock that could tip it into deflation — a sustained bout of falling wages and prices that may lead to recession. Compounding the fears is an economy that has slowed significantly since the third quarter.

Fed Chair Janet Yellen told Congress that to raise rates, Fed officials must simply be “reasonably confident” that inflation will drift toward the Fed’s target in the medium-term. As long as the unemployment rate continues to fall and inflation doesn’t slip further, O’Sullivan predicts, the Fed will begin liftoff in June. Supplying confidence that inflation should edge up soon: Oil prices have stabilized since late January, and the dollar is likely to rise more slowly in coming months, says Nomura U.S. Chief Economist Lewis Alexander.

But a Morgan Stanley report says Fed officials have voiced worries about squelching the recovery if rates go up too early. The research firm expects the Fed to drop the “patient” language in this week’s statement but to wait until early 2016 to raise rates as it seeks a clearer signal that wage growth and inflation are gaining momentum.

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