April 25 (Bloomberg) -- Federal Reserve officials are wondering how long consumer-price inflation can stay in the neighborhood of 4 percent without undermining their credibility as inflation fighters.

Over the 12 months ended in March, the cost of energy in the consumer-price index shot up 17 percent and food items rose 4.5 percent. The remaining three-fourths of the index, the so-called core CPI, was up a modest 2.4 percent.

Like everybody else, Fed policy makers have been surprised by the repeated surges in world oil prices and more recently by record costs for corn, wheat, rice, soybeans and dairy products. And they have taken comfort that all that's needed to bring the overall inflation rate down is for key commodity prices to stabilize.

Except that hasn't happened.

The prospect of elevated inflation and the risk to Fed credibility make it likely that if the Federal Open Market Committee chooses to reduce its 2.25 percent target for the overnight lending rate at its meeting April 29-30, the cut will be only a quarter-percentage point after a series of larger ones.

Fed funds futures contracts indicate investors yesterday put about an 80 percent probability on such a 25-basis-point cut next week.

The contracts also put a 20 percent probability on the FOMC's leaving the target unchanged, which would be the better policy choice at this point because of the threat to the Fed's credibility.

Trace of Optimism

A measure of optimism has returned to financial markets, and that gives Fed officials an opportunity to pause after cutting the lending rate target by 300 basis points.

Not unbridled optimism by any means, just a sense that markets and most institutions have survived the worst of the financial turmoil and a period of slow improvement and better economic growth lies ahead.

Whether the committee decides to do one more quarter-point cut or not, the statement issued after the meeting is likely to be pretty neutral in tone, neither promising more cuts nor ruling them out. Futures contracts also put a high probability on no cuts at the FOMC's June and August meetings if the target is lowered to 2 percent next week.

Fed officials have to sort their way through a number of issues pushing them in different directions. The most difficult is whether earlier rate reductions help the sputtering economy enough so that they could respond to inflation pressures by standing pat.

Growth Figures

One useful piece of information they will get when they gather for the second day's session is the Bureau of Economic Analysis's advance estimate for first-quarter economic growth. The growth rate is forecast at just 0.15 percent, according to a Bloomberg survey, weak though not negative.

Still, consumer spending should get a modest boost beginning next month when the Treasury Department sends out the first tax- rebate checks of as much as $1,200 for eligible households as part of the stimulus measures passed earlier this year. That should help keep growth in positive territory.

Most recent economic data have been mixed, with much of the economic weakness concentrated in housing. New-home sales, reported yesterday, fell for a fifth straight month. Sales of existing homes, though, have declined only slightly over the past six months.

Payroll employment fell again last month. On the other hand, initial claims for unemployment benefits have stayed below the level usually associated with a recession. While it could still happen, there isn't any sign of the onset of a serious recession.

Dollar's Decline

Fed officials have spoken about the existence of ``downside risks,'' and they are certainly there. Officials have also cited the risk of accelerating inflation and the danger of lost credibility for the central bank.

Lower short-term interest rates have contributed to the falling U.S. dollar, which touched a record low of $1.60 against the euro on April 22. The dollar's weakness has made U.S. exports more competitive abroad, which has bolstered U.S. industrial output. The weakness has also made imports more costly and added to inflation pressures -- another reason officials might not want to cut rates again.

Yet food and energy prices are a big problem and there's nothing the Fed can do about them, including being sure where they are likely to go. Futures contracts for some important commodities underscore the volatility of those markets.

Oil Prices

Contracts for crude oil for June delivery closed in floor trading yesterday at $115.99 a barrel, up from about $97 at the beginning of the year.

The longer that oil prices stay high, the more likely they will get built into energy-influenced costs such as airline fares, transportation rates and chemical prices. Slow economic growth, of course, makes it harder for businesses to pass on those higher costs.

A gesture by the Fed, such as leaving the lending-rate target unchanged next week, might help hold down inflation expectations and discourage passing on higher costs.

With all the rest of the Fed's efforts to add to market liquidity solidly in place, why not make the gesture?

(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: April 25, 2008 02:31 EDT