Another U.S. Federal Reserve interest rate cut this week is a foregone conclusion as far as financial markets are concerned, but a heaping helping of global inflation data may leave a sour aftertaste.
The Fed is widely expected to follow the central banks of Canada and England with a quarter-percentage-point reduction in the benchmark federal funds rate on Tuesday and some economists predict a more aggressive half-point cut to prevent a housing downturn and credit contraction from derailing the economy.
But nagging inflation, largely from steep energy and food prices, is forcing central bankers onto a narrow plank as they seek the right balance between promoting growth and keeping prices in check. Inflation hawks will likely be heard at least faintly in the closely watched statement announcing the Fed's decision.
Last week, the European Central Bank kept rates on hold but acknowledged that some members had considered a hike to tamp down rising prices. ECB President Jean-Claude Trichet said the euro zone central bank stands ready to counter upside risks to price stability, which sent a signal to investors that rate cuts were unlikely any time soon.
The Fed will probably take a softer tone, leaving the door open to lowering borrowing costs further early next year, amid expectations that a slowing economy will ease price pressure in other key areas such as wages.
However, recent data hasn't been going the Fed's way. A report on the U.S. labor market's health on Friday showed wages rose by a surprisingly large 0.5 percent in November.
PPI A 'SHOCKER'
Higher-than-expected readings on the U.S. producer and consumer price indexes, due on Thursday and Friday, may prompt some second-guessing, particularly if the Fed does opt for the more aggressive half-point cut. For details on major global economic data due out this week, click on ID:nL07400930).
Global Insight expects a hefty 2.5 percent rise in the PPI, which would be the fourth-largest jump since the index began in 1947. But the core rate, stripping out food and energy costs, should remain relatively tame.
While the top-level number will be a shocker, we do not expect the moderate rise in the core rate to cause Fed Chairman Ben Bernanke to fall out of bed at night, Global Insight's economists wrote in a note to clients.
Exporting powerhouse China's consumer price index is also expected this week, and will likely show inflation moderated only slightly from an 11-year high notched in October. Many economists, including former Fed Chairman Alan Greenspan, think China's deflationary power is petering out, and rising domestic prices will filter through into its exports.
To be sure, the U.S. dollar has shown signs of stabilizing, and oil has dipped below $90 per barrel, giving inflation-watchers some breathing room. However, with OPEC declining to boost output and with crop prices still high, food and energy costs are likely to remain elevated for some time.
Perhaps more worrisome, there are signs that U.S. consumers' inflation expectations may be coming unstuck, another threat to already sluggish spending growth.
The Reuters/University of Michigan Surveys of Consumers, released on Friday, found that one-year inflation expectations edged up to 3.5 percent in December, the highest reading since August 2006. Five-year expectations also rose.
The outlook for growth is quite dire at the same time inflation expectations are rising, said T.J. Marta, fixed income strategist at RBC Capital Markets in New York, adding that the Fed would no doubt cut rates now to avoid a recession, but may be hiking rates again by the end of next year.
The Economic Cycle Research Institute's U.S. Future Inflation Gauge, designed to anticipate cyclical swings in the rate of inflation, rose to 119.7 in November from an upwardly revised 119.0 in October.
For now, risks to growth appear to outweigh inflationary pressures, but if next week's data show prices rose more than expected, central bankers may be feeling more heat.
(Editing by James Dalgleish)