A close call for the Fed?

WASHINGTON — The weakening economy may prompt Federal Reserve policymakers to hold interest rates steady, taking their first break in a rate-raising campaign that began more than two years ago.

Or, they may bump up rates yet again to fend off inflation.

In one of the most nail-biting times leading up to a Fed meeting in recent years, economists think it will be a close call when policymakers convene today to examine interest rate policy in the United States.

The Fed’s goal is to slow the economy enough to prevent inflation from taking off while not crimping economic activity so much that it throws the economy into a recession.

With the economy and job creation losing momentum, some investors and economists believe the time is ripe for Fed Chairman Ben Bernanke and his colleagues to take a breather.

The Fed, which has been steadily lifting rates since June 2004, now has 17 quarter-point increases under its belt.

Not all of those increases, though, have yet to be felt in the form of slower economic activity. It can take a year or so for a rate increase to work its way through the economy.

“The need to incorporate lags between policy actions and effects on the economy is a key issue,” explained Janet Yellen, president of the Federal Reserve Bank of San Francisco. “So if we kept automatically raising rates until we saw inflation start to respond, we most likely would have gone too far,” said Yellen, a voting member on the Fed committee that sets interest rates.

All told, the Fed’s increases thus far have left borrowing costs at their highest point in more than five years.

The federal funds rate, the overnight rate that banks charge each other, now stands at 5.25 percent. The funds rate influences other interest rates, including mortgage rates, and is the Fed’s main tool for influencing economic activity.

Commercial banks’ prime lending rate — for certain credit cards, home equity lines of credit and other loans — has moved up along with the funds rate and is now 8.25 percent.

“I think the Fed will take a pause. The Fed wants to allow the economy to catch up with the rate increases that they have already ordered,” said Lynn Reaser, chief economist at Bank of America’s Investment Strategies Group.

Higher borrowing costs have played a role in curbing consumers’ appetite to spend and cooling the once-hot housing market, factors that have dampened overall economic activity. Cautious businesses, meanwhile, have tightened their belts and slowed hiring.

The nation’s unemployment rate jumped to a five-month high of 4.8 percent in July, the government reported Friday. The weak employment report put new pressure on the Fed to take its foot off the economic brakes, said analysts who favor leaving rates alone.

Bernanke told Congress last month that slowing economic activity should eventually lessen inflation pressures. Nonetheless, Bernanke also said the Fed must stay on guard against the risk that lofty energy prices could spread inflation through the economy.