Citing the risk of high inflation, the U.S. Federal Reserve voted to hold the Federal Funds rate steady at 2.0% yesterday (Wednesday).

“Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased,” the accompanying Federal Open Market Committee (FOMC) statement read.

The statement did not allude to any future rate hikes at the next FOMC meetings scheduled for August or September. It was a very balanced statement overall, acknowledging the dual threats of stagnation and inflation currently facing the U.S. economy.

“It is more or less a neutral statement, which is consistent with policy on hold pending more clarity,” James O’Sullivan, a senior economist at UBS Securities LLC in Stamford, Conn., told Bloomberg News. “They are not tipping their hand for the next meeting.”

There’s no clear-cut course of action before the Fed, as its Chairman Ben S. Bernanke and the other FOMC members must carefully weigh the dual threats of stagnation and inflation facing the U.S. economy.

Skirting Stagnation

Gross domestic product growth clocked in at 0.9% for the first quarter, an increase from the 0.6% GDP growth in the last three months of 2007.

But several recent economic reports show the U.S. economy remains sluggish at best, and consumer sentiment is at a record low. Unemployment climbed 0.5% in May to 5.5%. The housing market continues to suffer and drag on other sectors, while some areas of the credit markets remain near frozen.

“Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters,” the FOMC statement read.

The Fed must execute caution, as a hasty switch in tactics could do more harm than good, as it seems clear economic recovery is far from a certainty at this point.

“The Fed is going to need to start hiking interest rates at some point to start to deal with inflation,” Matt King, chief investment strategist with Bell Investment Advisors in Oakland, Calif., told Reuters. “That’s a bigger risk than recession.”

Battling Inflation

Commodity prices are soaring with oil over $135 per barrel and food costs are escalating global hunger problems. Even excluding the volatile costs of food and energy, the so-called “core” consumer price index is running at a 2.3% annual clip, above the Fed’s desired 2.0% inflation target.

“The Committee expects inflation to moderate later this year and next year,” the statement read. “However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high.”

Many have called upon the FOMC to raise rates in order to battle inflation. At least one Federal Reserve Bank president remains concerned inflation, rather than slow economic growth, is the more dire threat. Richard Fisher, president of the Federal Reserve Bank of Dallas, dissented on today’s monetary policy decision, voting instead for a rate hike. Fisher also voted against lowering rates at the last two FOMC meetings.

Things could get ugly if Bernanke chooses not to follow through on his recent position against inflation and in favor of strengthening the dollar.

“Unless the inflation expectations and the numbers come down, they’re going to have to raise rates,” William Ford, a former Atlanta Fed chief who’s now at Middle Tennessee State University in Murfreesboro, said in a Bloomberg Radio interview before the decision. “If [Bernanke’s] saying we’re going to fight inflation but he’s all bark and no bite, division is what’s going to happen.”

Bernanke’s counterpart across the Atlantic, European Central Bank (ECB) President Jean-Claude Trichet has publicly proclaimed inflation his top priority and has even gone so far as to suggest the possibility of a 25-basis point ECB rate increase as early as July.

But many feel a single rate increase won’t be enough in the 15-country Eurozone, where inflation reached 3.7% last month, well-above the central bank’s 2.0% target rate.

“There is disagreement among ECB policy makers about the future course of monetary policy, but one increase will simply not be enough,” Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group PLC (ADR: RBS) in London, told Bloomberg. “At the end of the day, inflation concerns will rule.”

Source: Fed Holds Rates Steady in Face of Upside Inflation Risk