Aug. 29 (Bloomberg) -- Federal Reserve officials may be prepared to live with a pickup in inflation over coming months as they consider the cost to housing and jobs of higher interest rates.

``When you have a very visible strain in the economy like housing at present, something that probably won't break but just might, the Fed gives more weight to the potential for exponential losses,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``A policy shock would be more costly than usual at present.''

The decision to stop raising interest rates this month ``was a close call,'' among members of the Federal Open Market Committee, according to minutes of their Aug. 8 meeting. While price increases appeared to be more broad-based, policy makers said slower growth may ease pressures in coming quarters, and inflation expectations were still contained.

Fed officials viewed the deterioration in the housing market ``as a downside risk to the outlook for growth.'' New home sale cancellations, a leading indicator of real estate market, ``had spiked higher,'' the minutes showed.

Since the meeting took place, government and industry figures have shown a deepening slump in residential real estate, an industry that fueled economic expansion for five years. A private survey released today showed consumer confidence fell this month to the lowest level since November.

Core Inflation

Consumer prices excluding fuel and food over the last three months rose at the fastest pace since 1994, while consumers' inflation expectations as measured by the University of Michigan jumped in August.

``Most participants expressed the view that core inflation was likely to decline gradually over the next several quarters, although appreciable upside risks remained,'' minutes of the Fed's meeting this month showed. After two years of rate increases, ``members generally saw limited risk in deferring further policy tightening that might prove necessary, as long as inflation expectations remained contained.''

Fed forecasts presented to Congress last month predicted that inflation will hover around 2 percent to 2.25 percent next year -- a level that's higher than what some policy makers, including Chairman Ben S. Bernanke, have said is desirable. Bernanke added that inflation will probably recede in 2008.

``When I saw the forecasts, it seemed there was a tolerance for that inflation correction process to last quite a while,'' said Robert Parry, president of the San Francisco Fed from 1986 to 2004. ``I would not be pleased that here you are in the middle of June 2006 and expecting inflation still being outside your range through much of 2007.''

Recession of 2001

The strategy doesn't have universal backing at the central bank, which in the past erred on the side of tightening credit too much, helping induce the recession of 2001. The Fed lifted the benchmark rate by half a percentage point in May 2000, after the Nasdaq Composite Index had already fallen about 29 percent from its peak in March.

Records of the August gathering may give insight into whether disquiet with the decision went beyond the opposing vote by Richmond Fed President Jeffrey Lacker. Presidents of the dozen regional Fed banks attend policy meetings, though only five join the seven Washington-based governors in voting this year, according to rotation rules.

Lacker Dissent

Lacker, 50, favored an 18th consecutive quarter-point increase, according to the statement by the Fed after the rate decision. The dissent was the first under Bernanke, who became chairman in February.

``He was supporting a policy option that was given serious consideration by most members of the committee,'' said Brian Sack, senior economist at Macroeconomic Advisers LLC in Washington and a former economist at the Fed's Division of Monetary Affairs.

Chicago Fed President Michael Moskow, 68, who isn't voting this year, said on Aug. 22 that the risk of inflation remaining too high is greater than the risk of growth being too low.

Bernanke, 52, told Congress last month that rate changes take some time to work their way through the economy and that a housing downturn posed a risk to growth. He said in March 2005 that his comfort zone for inflation excluding food and energy was 1 percent to 2 percent, a range he hasn't disavowed since becoming Fed chairman this year.

``I am increasingly getting the feeling that is on the low side,'' said Richard Berner, chief U.S. economist at Morgan Stanley in New York. ``The Fed may implicitly be choosing a slightly higher inflation objective than previously thought.''

Patient Stance

The Fed's August statement said that ``inflation pressures seem likely to moderate over time.'' Berner and his counterparts at Lehman Brothers Holdings Inc. and JPMorgan Chase & Co. detect a more patient stance, and say Bernanke may be wary of the costs of being more aggressive in reducing inflation.

It now takes a bigger increase in unemployment to bring inflation down by one percentage point, an equation economists refer to as the sacrifice ratio. A prolonged slump in housing may also have a large impact on household spending decisions; economists at Merrill Lynch & Co. estimate housing contributed 2 percentage points to growth, or about 60 percent, over the last three years.

``There is no reason to hammer the economy to bring inflation down another half point,'' said James Glassman, senior economist at JPMorgan Securities Inc. in New York.

Home Sales

Sales of previously owned homes fell in July to the lowest in more than two years and the supply of unsold homes jumped to a record. Gross domestic product rose 2.5 percent last quarter, according to a preliminary government estimate, less than half the pace of the preceding three months.

The strategy of letting inflation drift slowly lower has its own risks, economists note. The economic pain to lower inflation may be even higher. Households and businesses could take their cue from what inflation is rather than where the Fed predicts it will be in 18 months, raising their expectations of price increases.

``If the Fed gets behind through delaying, that would be the most negative scenario,'' said Dean Maki, chief economist in New York at Barclays Capital Inc., which forecasts two more quarter-point rate increases this year.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net

Last Updated: August 29, 2006 14:01 EDT