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Rising Inflation And Weak Economy Split Fed, Stir Worries On Wall Street

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Market experts and government policy-makers have become increasingly torn between two encroaching dangers: rising inflation and a struggling economy. The controversy over which one represents the most serious threat has divided economists and created a split within the Federal Reserve - a state of uncertainty only exacerbated Friday by a resurgence in oil prices and the release of another weak employment report.

Doubt about the central bank's ability to simultaneously fight inflation and support the economy could become a serious source of weakness on Wall Street. Worries along these lines sparked a nearly 400-point sell off in the Dow on Friday.

Rising oil prices and deteriorating inflation expectations have made it difficult for the Fed to continue its campaign of lowering interest rates. Meanwhile, shaky economic data have limited the central bank's ability to control rising prices.

Chris Lowe, Chief Economist at FTN Financial, said of the Friday's sharp decline on Wall Street, "people are thinking that with an unemployment rate at 5.5 percent there's just no way Bernanke can raise rates. If the Fed can't raise then so much for the inflation restraining and stronger dollar talk we heard in these two speeches earlier in the week."

Earlier this week, Federal Reserve Chairman Ben Bernanke surprised markets with unusually blunt comments about inflation's impact on the beleaguered dollar. The remarks seemed to signal a clear end to the recent string of interest rate cuts, which have taken the Fed's benchmark rate from 5.25% last summer to a level of 2% now.

However, a closely-watched employment report released on Friday may have undermined the Fed's ability to fight inflation. A sharp jump in the country's unemployment rate suggested that the economy has not begun to rebound yet - a fact that would likely prevent the Fed from raising rates to fight inflation.

Some economists believe that a turn toward inflation fighting is pre-mature at this point, especially in the wake of the recent jobs data.

John Schmitt, a senior economist at the Center for Economic Policy Research, said there is "no serious problem with inflation, but there is a serious problem on the employment side." He added that the Federal Reserve needs to "be prepared to give more leeway on this point."

Meanwhile, other economists feel that inflation problems have been understated in the recent economic data.

"The recent rise in inflation has not yet been properly captured by the variety of inflation indexes used by the market to assess the pricing environment," explained Joseph Brusuelas, Chief Economist and VP of Global Strategy at Merk Investments.

Beyond dividing economists, though, the debate about the best Fed policy has also caused a split within the central bank. The hawkish camp, led by Dallas Fed President Richard Fisher and Richmond Fed President Jeffrey Lacker, have become increasingly vocal about their criticisms of the Fed's accommodative stance.

Lacker made comments earlier this week arguing that the Fed might cause more problems by increasing its intervention.

Economist Brusuelas said of Lacker's "pointed jab" that it "provides a real glimpse into not only the moral hazards created by the bailout of Bear Stearns, but the real dangers created by the very accommodative policy that has characterized Fed policy for much of the past several years."

Earlier this year, the Fed brokered a deal for famed Wall Street firm Bear Stearns to be acquired by JP Morgan (JPM) in a last-minute effort to keep Bear out of bankruptcy. While some lauded the deal for avoiding general market instability, others argued that it increased the so-called "moral hazard" in the markets - the risk that bailing out the firm will only encourage unnecessary risk-taking in the future.

Lacker's comments were just the latest sign of a split within the Fed. Dallas Fed President Fisher, along with Philadelphia Fed President Charles Plosser, voted against the Fed's last interest-rate cut, signaling a desire to remain tough on inflation with their preference to leave rates alone. Fisher and Plosser also voted against the previous Fed cut, again preferring less aggressive action.

Wall Street showed significant worry on Friday that the Fed will be unable to manage inflation, while still steadying the economy. The Dow dropped about 395 points, a more-than-3% slide that took the index to its lowest level in more than 2 months. The Nasdaq and S&P 500 showed similar weakness, falling by 75 points and 43 points, respectively.

This came largely as the result of government statistics released early Friday, which showed that the unemployment rate jumped to its highest level in more than 3-and-a-half years, climbing to 5.5 percent in May from a level of 5.0 percent in April. Also, the report showed further job losses during the month, though payrolls fell by a lower-than-expected 49,000.

Meanwhile, the same report showed that average hourly earnings - a key measure of inflation pressures in the labor market - climbed by a larger-than-expected 0.3% in the month.

This data underlined a general market fear of "stagflation" - an economy that has stagnant growth and high inflation.

The tension between fighting inflation and supporting the economy can sometimes be seen within the remarks of a single Fed speaker, as was the case Friday in comments by St. Louis Fed President James Bullard.

In his first major speech since taking over as head of the organization, Bullard said that inflation will become a "more pressing concern" in the second half of the year. He also characterized inflation expectations as "fragile," and cautioned of a very real risk of a breakdown.

The warning about inflation expectations could be particularly worrisome for the Fed, as most economists believe that once people come to expect high inflation, it becomes ingrained in their consciousness and begins to take a significant toll on the economy.

Still, Bullard supported the Fed's recent policy actions, saying they were justified by the current state of the economy.

"Given the current economic environment and the outlook for the next 18 months, my view is that policy is appropriately calibrated at this time," he said in remarks given at the Wisconsin School of Business in Madison, Wisconsin.

He continued, "In short, the Fed has created a low-interest rate environment that should allow the economy to continue to adjust to the drag from the housing sector and the aftermath of financial market turmoil."

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