Wall Street is watching as Fed treads a fine line

By Madlen Read

June 23, 2008 12 AM PT

The Associated Press

After the Federal Reserve’s meeting this week, Fed policymakers are expected to voice a tough stance on inflation. Talk about poor timing.

Though Wall Street’s inflation concerns have not abated -- crude oil remains above $134 a barrel -- worries about the health of the U.S. financial system and broader economy have returned in force.

Last week, Citigroup Inc. warned that it expected substantial debt losses in the second quarter; two bond insurers lost their Moody’s AAA rating; Fifth Third Bancorp said it needed to raise $2 billion in capital; the broker MF Global said widening credit spreads would damp its profit.

This means the market is going to have a hard time stomaching any hint from policymakers that an interest rate hike is on the way. When borrowing gets more expensive, the economy tends to get even more anemic.

“I don’t know that there’s anything they can say in their policy statement that would cause the market to breathe a sigh of relief or cause a big updraft in the market,” said Richard Sparks, a senior equity analyst at Schaeffer’s Investment Research in Cincinnati. “The best they could do is remain neutral. . . . But I agree with most people that they’re more likely to emphasize price pressures rather than the potentially weakening economy.”

Few investors expect the Fed to increase the key interest rate at its meeting Tuesday and Wednesday, after lowering it over the last year. Many don’t expect a rate hike until the fall, or until early next year. But nearly all believe, after speeches by Fed officials over the last few weeks, that policymakers are finished with lowering rates because of the plunging dollar and soaring energy costs.

“There’s no question the Fed is walking on a tightrope here. They’re in a box,” said Peter Cardillo, chief market economist at New York-based brokerage Avalon Partners Inc. He pointed to the sluggish economy, the threat of rising inflation and flooding in the Midwest that is destroying crops.

“If they were to raise [rates], that could put further weakness in economic activity. But by the same token, by raising, that could help stabilize the dollar and help reverse inflation,” Cardillo said.

Wall Street’s trio of troubles -- the economy, inflation and financials -- drove the Dow Jones industrial average down by 3.8% last week. It closed below 12,000 for the first time since mid-March. The Standard & Poor’s 500 index ended the week down 3.1%, and the Nasdaq composite index closed 2% lower.

“Right now, I think we’re kind of moving lower because there’s nothing positive on any front,” Sparks said.

In addition to the Fed meeting, this week brings data from S&P;/Case-Shiller on April home prices, May orders for durable goods, May sales of new and existing homes and -- in perhaps the most revealing report for the market -- personal income and spending in May.

The Commerce Department’s personal spending reading is expected to show a 0.6% increase, according to the median estimate of economists surveyed by Thomson Financial. Income is anticipated to have increased 0.4%, while inflation at the personal spending level -- as measured by the core personal consumption expenditures deflator -- is predicted to have ticked up 0.2%.

Another important piece of data is the Commerce Department’s final reading on first-quarter gross domestic product. The estimate was revised up last month to 0.9%, and economists, on average, expect the government to ratchet it up again to 1.0%.

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At a Glance

oday

Senate Energy and Commerce subcommittee holds hearing on energy speculation.

Quarterly earnings report due from Walgreen.

Tuesday

Federal Open Market Committee meets to discuss interest rates.

The S&P;/Case-Shiller index of home prices is released.

The Conference Board releases its consumer confidence index.

Quarterly earnings report due from Kroger.

Wednesday

Commerce Department reports on new-home sales.