Economy: Inflation may not be the biggest risk

Markets have the shakes. The housing sector is searching for a bottom. Consumers look fatigued. Oil prices are volatile.

Is an economic soft landing supposed to feel this rough?

The Federal Reserve meets today to discuss interest rate policy, bolstered by data pointing to the slower, sustainable growth and gradually moderating inflation it has predicted. But Fed Chairman Ben Bernanke and his colleagues also face turmoil in stock and bond markets, despite Monday's stock rally, as traders worry that an economic expansion built largely on easy credit is too brittle to hold together.

In the near term, Fed officials have given no hint of budging from their current policy of keeping interest rates steady as they focus on tamping down inflation. The central bank has held a key short-term rate at 5.25% for more than a year.

The question is what happens to the economy and Fed policy later this year and into 2008. Economists, including those at the Fed, have been reducing their growth estimates. While many expect the nation to avoid a sharp downturn, given the strong world economy, tight labor market and healthy corporate profits, the shaky financial markets have added a new layer of risk.

Nariman Behravesh, chief economist at Global Insight, says the economy appears to be in a soft landing, predicting a slow 2% to 2.5% annual growth rate ahead. He adds, however, that the economy's "deceleration does make us vulnerable to another shock."

Spreading credit crunch

The big, emerging area of worry is the financial markets, where interest rates on some corporate debt have jumped in recent weeks. Soaring defaults in subprime mortgages, which are higher-priced loans to consumers who have impaired credit, have forced dozens of lenders out of business and torpedoed investors who bought bonds backed by the loans. That, in turn, has prompted even lenders of higher-quality mortgages to tighten terms or stop offering some products, which could further delay a housing recovery and cut overall growth.

Martha Pomerantz, principal and co-chair of the investment committee at Lowry Hill, a $7 billion high-end individual money management firm, says the strong global economy means companies will continue to find markets and financing and to post healthy profits.

Financing for corporate deals has been historically cheap and is now simply moving to more normal levels, she says. There's a "movement of money from riskier markets to higher-quality companies that … have good prospects for durable earnings growth," Pomerantz says.

Others are less sure, saying the bills are coming due for a cheap credit binge that resulted in too many houses no one wants to buy and a slew of questionable business deals.

"Slowly but surely, investors are opening their eyes to the reality of the widespread credit excesses of the past and tightening the noose around the neck of future credit availability," investment advisory firm Caldwell & Orkin said in a recent analysis.

The economy has generally unfolded as the Fed has predicted in the past year and a half, though the central bank last month reduced its growth forecast, calling the housing correction worse than expected.

Signs of strength

Unemployment is a low 4.6%. An index of core inflation, a measure that doesn't include volatile food and energy prices, has declined from 2.5% in November to a 1.9% rate in the 12 months ended in June, near the top of the Fed's informal comfort zone.

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