Aug. 7 (Bloomberg) -- The July labor market report tipped the scale in favor of a pause in the Federal Reserve's drive to raise interest rates to keep inflation under control.

After 17 consecutive increases in the target for the overnight lending rate to 5.25 percent, officials should take a pass at tomorrow's Federal Open Market Committee meeting.

With the number of payroll jobs up only 113,000 and the unemployment rate rising to 4.8 percent from June's 4.6 percent, the Aug. 4 report provided further confirmation -- if any was really needed -- that U.S. economic growth has slowed significantly and may continue to do so.

Certainly the door is open for the FOMC to leave rates unchanged tomorrow. After digesting details of the labor report, investors put the probability of another rate increase at only 17 percent, down from 41 percent the day before, according to federal funds futures contracts on the Chicago Board of Trade.

That suggests there wouldn't be much of a backlash from analysts wringing their hands about Fed Chairman Ben S. Bernanke being ``soft on inflation'' or about the loss of Fed credibility as an inflation fighter.

After all, a pause would be just that. You can be sure that if the target is left unchanged, the FOMC statement will emphasize there could be further rate increases later if they are needed.

On the other hand, the Fed may be done if growth remains subdued and core inflation eventually begins to taper off. Fed officials' forecasts show they don't expect core inflation to drop back below 2 percent overnight.

Uncertainty

As the economic news has come in since the last FOMC meeting at the end of June, the officials have been genuinely uncertain what they should do the next time around. For instance, on July 31, St. Louis Federal Reserve Bank President William Poole told reporters the odds of another increase in the lending rate target were 50-50.

The issue, of course, is whether the 425 basis-point increase in the target since June 2004 will be enough to cap the recent acceleration in core inflation, which is now higher than the officials would like it to be.

At least a few FOMC participants would prefer to see another quarter-point increase tomorrow, partly because they remain concerned there is so much liquidity available that monetary policy isn't biting.

With growth slowing, others would prefer a pause, particularly given the lags with which changes in real interest rates affect the economy. A substantial portion of impact from those 425 basis points has yet to be felt, in their view.

Yellen's Views

In a speech on July 31, Janet L. Yellen, president of the San Francisco Fed, acknowledged those lags, which in both 1995 and 2000 caused the Fed to continue tightening too long.

``It appears to me that the federal funds rate currently lies in a vicinity that is roughly appropriate for the Fed to attain its key objectives over the medium term,'' said Yellen, who is a voting member of the FOMC this year. ``If we kept automatically raising rates until we saw inflation start to respond, we most likely would have gone too far.''

As an economist who is both a former Fed Board member and a former chairman of the Council of Economic Advisers, Yellen's views carry particular weight during FOMC discussions, according to a number of other committee participants.

The immediate goal in terms of growth is to keep it at about 3.25 percent, which is roughly how fast most Fed officials believe the economy can expand without causing the jobless rate to decline. Over time, that should be sufficient to allow core inflation to fall very gradually -- assuming energy prices stabilize, most of the officials think.

Other Data

Economist Ray Stone of Stone & McCarthy Research Associates told his clients the July labor report indicates that goal may already have been achieved.

``In the 12 months ending in July, payroll growth has averaged only 145,000 a month, and in the three months ending in July only 112,000,'' Stone said. ``This pace of payroll growth should be considered consistent with stabilization or even a slight further increase in the unemployment rate over time.''

Meanwhile, other recent economic data on consumer spending, the housing sector and business investment also point to a sustained softening of growth.

Consumers, facing gasoline costing $3 a gallon, have cut back their purchases of other items so that in the second quarter they rose at an inflation-adjusted 2.5 percent annual rate, as did gross domestic product.

`Handoff' Concept

Business investment in structures, equipment and software -- which many economists, including those at the Fed have been counting on to take up the slack as consumer outlays weakened -- increased at only a 2.7 percent rate in the quarter. All of the growth was in investment in structures while businesses trimmed equipment and software spending.

Moreover, revisions to GDP for 2003, 2004 and 2005 showed that business investment was not as strong as earlier estimates indicated.

On Aug. 1, economists at Goldman Sachs Group Inc. wrote in a financial market comment, ``We have long been skeptical about the `handoff' concept -- the idea that capital spending will accelerate while household spending continues to slow, cushioning any impact on the overall growth of the economy.''

``It makes little sense for businesses to accelerate their capital-spending plans at a time when final consumer demand -- the largest source of demand -- is decelerating,'' they said.

And in the second quarter, new housing construction spending fell at a 6.3 percent annual rate, underscoring the new weakness in that sector. The reduction in housing wealth is another reason consumers are cutting back.

Against that background, even with core inflation higher than Fed officials wish, a pause tomorrow in raising the overnight lending rate again makes sense. Overshooting didn't make sense at the end of the Fed's last two tightening cycles, and the FOMC ought to pause before doing it again.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net

Last Updated: August 7, 2006 03:45 EDT