The Federal Reserve finds itself in an unusually tricky position. Normally, it is concerned with trying to balance the need for economic growth against the risk of letting inflation get too high. If growth is very strong and inflation threatens, the Fed may raise interest rates to cool rising prices, and if the economy is too weak, the Fed may cut rates to spur growth.

At present, growth is sluggish and prices are rising. Interest rates are low, and the Fed would naturally be tempted to raise them at this point to fight inflation, even at the cost of creating a drag on growth.

Today, however, the Fed must wrestle with a third challenge beyond the growth and inflation dilemma: the issue of financial stability. Over the past year credit and housing crises have put banks and other financial institutions on shaky footing. Because these institutions enable the global financial system to function, their health—and market participants’ confidence in them—is of paramount concern.

Over the past few months, banks have trimmed assets from their balance sheets, cut costs and raised new capital, allowing them to return to a more traditional business model in which they borrow short term money at low rates, and lend it over long terms at higher rates. If the Fed were to raise interest rates now (in order to fight inflation), this model—and the return of stability to the financial system— could be compromised.

In testimony to Congress last week, Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson highlighted the complexity of the three-pronged problem and signaled that their primary concern is to ensure financial stability, even if that means waiting to tackle inflation. In response to their comments, the market’s expectations of a near-term rate hike, as measured by Fed Funds futures, declined, and bank shares led the stock market higher.

Bank stocks also got a boost last week and early this week on indications that many of them appear to be working through the financial storm, if not exactly flourishing. Quarterly earnings from Citibank, JP Morgan Chase, Wells Fargo, and Bank of America were down, but better than expected. Low interest rates have helped keep borrowing costs down, and the torrent of losses on subprime-related assets may be slowing.

While challenges in the financial sector persist, banks’ capital positions are slowly being rebuilt, and the government has shown a willingness to intervene if critical players in the economic system like Fannie Mae and Freddie Mac appear on the verge of failure. The question now is how long the Fed can wait to raise rates while the financial system recovers more fully. It will be a delicate balancing act; if the Fed has to tighten rates, banks will have a harder time returning to profitability. However, we believe slowing global growth will help cool inflation (including commodity prices) and help mitigate the need for significant rate hikes.

Consumer and producer inflation heads higher
The Consumer Price Index (CPI), a key measure of consumer inflation, rose 1.1% in June, while the “core” rate, which excludes food and energy, was 0.3% higher. Year over year, the overall rate was up 4.9% (the highest since 1991), while the core rate was 2.4%—well above the Fed’s “comfort zone” of 1–2%. As has been the case for months, higher energy prices drove the overall rate up, but core prices reveal some impact on other consumer purchases.

Meanwhile, the Producer Price Index (PPI), which measures wholesale inflation, rose 1.8% in June, with the core rate rising 0.2%. Year over year, the PPI has jumped a very steep 9.1%, while the core rate has risen 3.1%. Higher producer inflation has the potential to crimp profit margins if those excess costs cannot be passed on to the consumer.

For their part, U.S. consumers have continued to shop despite a higher cost of living, though their buying has moderated somewhat. Retail sales grew just 0.1% in June versus a rise of 1.0% in May, amid weak auto sales and fading benefits from the government stimulus program.

Manufacturing sector remains sluggish, but keeps inventories in check
Industrial production rose 0.5% in June after declining –0.2% in May. While utilities made the greatest contribution to the rise (on higher demand for power during the hot summer months), the manufacturing sector rebounded slightly after a negative reading last month, driven higher by motor vehicle production. The manufacturing sector remains soft, however. Though exports are healthy, companies are finding it difficult to pass on their soaring materials costs. Fortunately, companies generally have been able to keep a lid on inventories as business has softened. Inventories rose 0.3% in May, below the rate of business and retail sales for the month.

Jobless claims elevated
Initial claims for unemployment rose 18,000 in the week ended July 12, after dropping a steep –58,000 the previous week. However, the earlier results were probably skewed due to the July 4 holiday. The smoother four-week moving average for the week ended July 12 fell a modest 4,500 to 376,500, an elevated level that is consistent with an economic slowdown, but below the rates seen during previous recessions.

Housing market woes continue
There was no letup for the housing market, as single family housing starts dropped –5.3% in June for a year-over-year decline of –26.9%. Multi-family housing starts rose, due to a rush to begin projects in New York City ahead of the implementation of stricter building codes. In a separate report, the National Association of Home Builders’ Housing Market Index fell to an all-time low. With huge inventories of unsold homes sitting on the market and banks tightening lending standards, the sector appears unlikely to contribute much to economic growth for the foreseeable future.