Wall Street balks as Fed's tightrope gets thinner

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 expects substantial debt losses in the second quarter; two bond insurers lost their Moody's "AAA" rating; Fifth Third Bancorp said it needs to raise $2 billion in capital; the broker MF Global said widening credit spreads will dampen 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 incrementally over the past 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 past few weeks, that policymakers are finished with lowering rates due to 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 house 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 trifecta of troubles--the economy, inflation and financials--drove the Dow Jones industrial average down by 3.78 percent last week. It closed below 12,000 for the first time since mid-March. The Standard & Poor's 500 index ended the week down 3.10 percent, and the Nasdaq composite index closed 1.97 percent lower.

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