US Fed seen holding rates steady as economy slows

WASHINGTON, Dec 12 (Reuters) US Federal Reserve officials are expected to hold interest rates steady on Tuesday and retain a cautionary warning about inflation risks, while taking stock of cooler economic growth.

A decision by the Fed to keep benchmark borrowing costs at 5.25 percent would extend an interest-rate pause policy-makers initiated when they stepped to the sidelines on Aug. 8 after a two-year string of 17 consecutive rate increases.

Holding steady would be in keeping with the view, expressed by Federal Reserve Chairman Ben Bernanke and colleagues, that higher-than-desired core inflation is a worry, but price pressures should ease as slower growth pushes up unemployment.

The Fed's policy-making Federal Open Market Committee is expected to announce its decision around 2:15 p.m. (1915 GMT).

''We do not expect the FOMC at Tuesday's meeting to depart from Chairman Bernanke's recent message that spillovers from the housing downturn will stay limited and inflation risks still predominate,'' Goldman Sachs Chief U.S. Economist Jan Hatzius said in a note to clients.

Bernanke called core inflation ''uncomfortably high'' in a speech on Nov. 28, adding there were risks prices would not recede in spite of the drags on growth from slowing housing markets and weakness at auto plants and other factories.

Fed Vice Chairman Donald Kohn renewed the warning on inflation early this month, saying that while policy-makers expect inflation to ease, ''the risks around that expectation are tilted to the upside,'' suggesting the U.S. central bank sees a greater chance of rates rising than falling.

Kohn pointed to tight labor markets and an economy that, while growing more slowly than at the beginning of the year, is expanding at a pace not that far below the speed limit for keeping inflation under control.

U.S. output grew at a 2.2 percent annual rate in the third quarter, slowing from 2.6 percent in the second quarter and 5.6 percent in the first three months of the year. Many economists think the long-term trend growth rate is around 3 percent.

Meanwhile, core inflation, which excludes volatile food and energy prices, rose 2.4 percent over the year through October, according to the Fed's favorite measure -- off only slightly from the more than 11-year high of 2.5 percent in August.

Many Fed officials have said their comfort zone for core inflation is between 1 percent and 2 percent.

The Fed's focus on inflation comes amid signs of a slowing economy that have many analysts expecting the U.S. central bank will change course sometime in 2007 and seek to ward off economic weakness by lowering interest rates.

A gauge of factory activity from the Institute for Supply Management dropped below the break-even point between expansion and contraction for the first time in 3-1/2 years in November.

In addition, the government reported that home prices edged up at a modest annual rate of 3.45 percent in the third quarter from the second quarter, the slowest quarterly rise since the second quarter of 1998.

A slowdown in housing is expected to dampen consumer spending. Wal-Mart, the world's largest retailer, said sales at its U.S. stores open at least a year fell 0.1 percent from November 2005, the first decline since April 1996.

''The combination of slower growth and reduced inflation risks, if it occurs, will thus allow the Fed to stay on hold for much of 2007, and to ease gradually as inflation moves lower late next year and into 2008,'' Morgan Stanley Chief U.S.

Economist Richard Berner said in a research quote.

In a sign that may have given comfort the Fed, the unemployment rate edged up to 4.5 percent in November from the 5-1/2 year low of 4.4 percent reached in October.

REUTERS PV RAI1139