Inflation still tops Fed’s worries

WASHINGTON —  Federal Reserve officials worried at their May meeting that inflation could exact a toll on the economy and saw risks of a sharp economic slowdown receding, suggesting interest rates would stay on hold for now.

“Some noted that a failure of inflation to moderate could entail significant costs, particularly if it led to an upward drift in inflation expectations,” minutes of the May 9 rate-setting meeting, released Wednesday, said.

Fed officials also voiced less anxiety about sluggish economic growth than they did earlier in the year. They thought turmoil in the U.S. mortgage market for borrowers with weak credit histories would not spread more broadly, and saw signs that weak business spending was reviving.

As a result, “these downside risks were judged to have diminished slightly,” they said.

The more-optimistic take on the economy spurred stock market rallies, pushing the Standard & Poor’s 500 to its first record high in seven years and the Dow industrials to a new high.

“Even though the Fed now believes that the housing contraction will be more severe than previously expected, a pick-up in manufacturing and business spending pointed to a slightly more encouraging outlook,” said Brian Bethune, a U.S. economist for Global Insight in Lexington, Mass.

“With a slight improvement to the short-term growth outlook, our conclusion is that the Fed will keep rates steady for several more months,” he said.

Futures markets remained priced for the Fed to hold rates steady at its next meeting in June, and probably in August as well, with the chance of a single rate cut by year-end seen at 50%.

The minutes showed a Fed that continues to see inflation as a greater source of anxiety than weak growth. Nearly all of the Fed policymakers continued to believe that inflation, excluding food and energy costs, was “uncomfortably high” and should come down more.

“Members agreed that considerable uncertainty attended the prospects for inflation, and the risk that inflation would fail to moderate as desired remained the committee’s predominant concern,” the minutes said.

At its May meeting, the Fed held benchmark interest rates steady at 5.25%, the level they hit in June 2006 after 17 straight quarter-point increases.