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Fed juggling inflation, economy as it considers rate cut, U. of I. expert says

4/29/2008

Anne Villamil
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Photo by L. Brian Stauffer
Economist Anne Villamil predicts the Fed will trim its key interest rate by another quarter-point at the end of its two-day meeting Wednesday, a cut that would lower the federal-funds rate to 2 percent from 5.25 percent since last year.

Jan Dennis, Business & Law Editor
217-333-0568; jdennis@illinois.edu

CHAMPAIGN, Ill. — Mounting worries about inflation will weigh on the Federal Reserve Board this week as it mulls a seventh cut in short-term interest rates in the last eight months, a University of Illinois economist says.

Anne Villamil predicts the Fed will trim its key interest rate by another quarter-point at the end of its two-day meeting Wednesday, a cut that would lower the federal-funds rate to 2 percent from 5.25 percent since last year.

But as concerns about inflation grow, Villamil says the bigger question is whether Fed Chairman Ben Bernanke and his colleagues will signal a pause from the recent spate of interest rate cuts aimed at propping up the nation’s faltering economy to ward off a possible recession.

“Continued rate cuts by the Fed can lead to inflation and a weaker dollar, and dollar weakness has been associated with commodity price inflation – especially in the price of oil,” she said. “Fed policy must weigh the risks of inflation versus the risks of continued financial sector weakness and its spread to the wider economy.”

Villamil says the Fed faces a tough juggling act, trying to keep inflation in check while also shoring up a sputtering economy that has been battered by continued weakness in the housing market.

“Falling housing prices and rising foreclosure rates are a drag on economic growth,” she said. “If housing prices fall to the point where owners have little or no equity in a property, they may default and this will trigger foreclosures, more downward pressure on housing prices, and losses at financial institutions. The Fed policy of lowering interest rates is one way to address weakness in housing, but it is not the only policy response.”

Villamil is a co-editor of the Annals of Finance and an associate editor of Economic Theory, the European Economic Review, and the Quarterly Review of Economics and Finance. Her research has examined financial contracts and the impact of inflation on public finance.

Editor’s note: To contact Anne Villamil, call 217-244-6330; avillami@illinois.edu.