Will Fed begin to raise rates soon?

Since last September, the Federal Reserve has cut interest rates 3-1/4 percentage points – a drop at each Fed meeting, plus some emergency reductions coming in the middle of the credit crisis.

This month, for the first time in 10 months, interest rates appear unlikely to change.

As Ben Bernanke convenes a Federal Reserve meeting Wednesday, Fed watchers will be looking for language that warns investors to get ready for a rate rise as early as August. If the Fed does signal it's preparing to hike short-term interest rates, it would indicate the central bank is now more concerned about inflation than the faltering economy.

The Fed's potential actions could have widespread effects aside from raising the cost of short-term borrowing by a small amount. The dollar, which has been pounded, could firm up. A stronger dollar might help pull some of the speculative money out of the oil market.

"If the Fed were to raise rates, it would have important implications for the dollar, for oil, for market psychology and interest rates," says Lyle Gramley, a former Fed governor and now a consulting economist at the Stanford Group in Washington. "But I think the reason they are reluctant to raise rates is that we still have a fragile economy."

Ahead of the meeting, the financial futures markets predicted a 60 percent probability that the Fed would raise rates in August. Earlier this month, the financial markets were far more certain: They gave an 80 percent probability of a rate hike.

"Signals were sent by Fed officials that they are not as eager to raise rates as the markets expected," Mr. Gramley says. "This is a very difficult situation for the Fed because if inflation gets out of hand, you pay a dear price to get it back down again."

Inflation, as measured by the Consumer Price Index, has been running at about 4 percent annually. However, the Fed often focuses on the "core CPI," which excludes food and energy. It has been rising at about 2.5 percent annually.

"Everyone in the universe questions the core CPI numbers," says Fred Dickson, chief market strategist at D.A. Davidson in Lake Oswego, Ore. "We see signs across the board that price increases are making their way into our lives, whether it's in the form of extra delivery charges or shrinking product sizes."

Because of the inflation concern, some Fed observers expect the Fed to include a stronger inflation warning in its statement. The statement can be a form of jawboning, or moral suasion, Mr. Dickson says. "They will let the capital markets act as a result of the jawboning since the Fed is basically hamstrung."

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