US Fed 'on horns of a dilemma' over rate rises

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The Independent Online

The US Federal Reserve is caught on the "horns of a dilemma" over whether to raise interest rates to curb rising inflationary pressures at the risk of triggering a crash in house prices, according to the International Monetary Fund.

The financial watchdog said it understood that the Fed had taken a pause in its programme of rate rises, but warned it ran the risk of allowing inflationary pressures from energy to become entrenched in households' expectations.

But Raghuram Rajan, the fund's chief economist, warned of a growing threat to the economy from a sudden slump in the property market, saying growth in US prices was close to zero.

"The Fed may soon be on the horns of a dilemma and monetary policy will need to be skilfully managed if the economy is not to be gored," Mr Rajan said

The IMF trimmed the forecast 3.4 per cent GDP growth for the world's largest economy but cut its outlook for 2007 by 0.4 percentage points to 2.9 per cent, saying the risks were for an even sharper slowdown.

Mr Rajan said: "The forecast housing slowdown is well and truly here with house appreciation very close to zero." He said figures showing a rising number of unsold homes on the market indicated that "things would get worse before they get better", implying that prices could start to fall soon.

He also said there had been little impact on consumer spending, which was supported by robust wage growth and falls in petrol prices. However, it was too early to say whether that spending would catch up with house prices, he added.

"It is appropriate therefore that the Fed has paused to study the incoming data, but pausing too long carries its own risks - tight labour markets, rising wages and falling productivity all imply that unit labour costs are increasing," he said. "It is clear that even as the economy slows, inflationary pressures are rising. If these become entrenched in expectations, the Fed will have to raise interest rates even higher and for longer."

The IMF confirmed it had lifted its 2006 forecast for global growth to 5.1 per cent from an April forecast of 4.9 per cent and predicted 4.9 per cent in 2007 from a previous projection of 4.7 per cent. There is a one in six chance that global growth could fall to 3.25 per cent or less in 2007, the IMF said.

It reiterated its appeal to major economies to reduce the global imbalances between vast surpluses in Asia and record deficits in the West, warning of a tiny risk of a devastating economic collapse if they failed.

In its World Economic Outlook report, the IMF said: "A major concern is that a disorderly exchange rate adjustment and global recession would risk a severe disruption in financial markets, hurting productive capacity, depressing access to credit and aggregate demand, and leading to asset price deflation. A downturn in activity could trigger a wave of protectionism, causing a substantial reduction in living standards across all countries."