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Near absent U.S. inflation cools rate-hike talk

The first hint of deflation in a quarter century means higher interest rates for most borrowers and savers are likely still months away - in spite of the U.S. Federal Reserve's surprise move Thursday to charge banks more for emergency loans.

The core consumer price index, which excludes volatile food and energy prices, fell in January for the first time since the 1982 recession, by 0.1 per cent.

Over all, prices crept up a modest 0.2 per cent last month, held back by falling prices for housing, new cars and air fares, the U.S. Labour department reported yesterday.

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The near absence of inflation calmed nervous investors, who were caught by surprise Thursday at the quick move by the Fed to increase its so-called discount rate.

The decision - though not the precise timing - touched off a lively debate about whether the Fed has begun tightening credit, or if it's merely a return to normalcy now that the credit crisis has eased, as Fed officials insist.

St. Louis Fed president James Bullard, who sits on the Fed's interest rate policy committee, said the discount rate move is part of a "normalization process," that also includes an orderly wind-down of the various emergency efforts the central bank launched to keep credit flowing during the worst of the credit crisis.

Raising the rate it charges primary dealers on emergency short-term cash "does not indicate anything one way or the other about what we might eventually do with the federal funds rate," Mr. Bullard said.

The federal funds rate - the bank's benchmark interest rate - has been set at a historic low of zero to 0.25 per cent since December, 2008. The Fed has said repeatedly in recent weeks that it plans to keep rates exceptionally low "for an extended period."

But some analysts are unconvinced.

"Maybe I'm just from the Midwest and don't quite understand the high fallutin' monetary braniacs at the central bank," remarked Andrew Busch, BMO Nesbitt Burns Inc. Chicago-based currency and public policy strategist. "But the last time I checked, when you raise rates it's called tightening."

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But as the January CPI numbers show, there's little evidence the Fed needs to cool down the nascent recovery just yet. The economy still has plenty of what economists like to call "slack" - empty plants, unsold inventory and laid off workers.

Yes, the economy is growing again. But most economists expect unemployment to remain near 10 per cent much of this year, and then decline only gradually.

What's more, banks borrow very little from the Fed at the discount rate - roughly $15-billion (U.S.) currently, down from more than $100-billion in late 2008. So there isn't likely to be much pass-through effect because the move is intended to force banks to look elsewhere for funding.

"Virtually no stimulus has been stripped from the economy by this step," explained Eric Lascelles, chief economics and rates strategist at TD Securities Inc.

Investors should focus instead on the easy money exit strategy laid out last week by Fed chairman Ben Bernanke.

Mr. Lascelles said it's a three-step process. The central bank will first work to reduce the $1.1-trillion excess reserves that commercial banks have on deposit with the Fed. Then , it will begin to raise the federal funds, probably in early 2011, according to Mr. Lascelles.

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Few economists expect a move up in the federal funds rate before late this year, in spite of the angst among many investors.

After rates begin to rise, the Fed will start selling off the large store of assets it scooped up in 2008 and 2009 to prop up financial markets, including billions worth of mortgage-backed securities and bonds issued by mortgage lenders Freddie Mac and Fannie Mae.

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About the Author
National Business Correspondent

Barrie McKenna is correspondent and columnist in The Globe and Mail's Ottawa bureau. From 1997 until 2010, he covered Washington from The Globe's bureau in the U.S. capital. During his U.S. posting, he traveled widely, filing stories from more than 30 states. Mr. McKenna has also been a frequent visitor to Japan and South Korea on reporting assignments. More

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