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U.S. Fed's optimism on economy high-stakes oil bet WASHINGTON, Aug 11 (Reuters) - The U.S. Federal Reserve's optimism about economic rebound in the face of soaring energy costs and slowing growth apparently reflects a genuine belief the summer pause will prove temporary. But many economists and former Fed officials saw the U.S. central bank's decision on Tuesday to stick to a course of gradual rate rises as a high-stakes gamble that energy prices can be brought under control. If not, the specter of "stagflation" -- the destructive coupling of rising prices and crawling growth that resists corrective policies -- could appear and, in the view of some, may already be lurking. "It really comes down to oil," former Federal Reserve Board Governor Laurence Meyer said on Wednesday. "Everything is predicated on oil prices kind of receding, not being much above $40 a barrel. If it goes to $50, it's a whole new game. If it stays at $45, it's a bit of a pain." The Fed, in raising the federal funds rate a quarter percentage point to 1.5 percent, blamed weak job creation and faltering growth in part on energy costs. Crude oil rose slightly on Wednesday after touching a record $45.04 a barrel and falling back Tuesday. Saudi Arabia attempted to cool prices by saying it had raised output sharply over the past three months and that Riyadh could immediately tap spare capacity to meet demand. However, bombing threats by an anti-U.S. militia in Iraq highlighted insecurity about Middle East supply. POISED FOR GROWTH "This softness likely owes importantly to the substantial rise in energy prices," the Fed on Tuesday in the statement announcing its rate hike. "The economy nevertheless appears poised to resume a stronger pace of expansion going forward." Some analysts were puzzled about where policy-makers felt reinvigorated growth will originate, but they said it was reasonable for the Fed to stick with its forecast unless it sees evidence the expansion is stalling. "There is nothing fundamentally wrong with the economy now," said former Fed Governor Lyle Gramley, who now consults for Schwab Research Group. "I think that you can persuade yourself that the fundamentals remain sound," he added, citing strong capital spending, buoyant consumer confidence and low business inventories. Gramley said oil prices were "the fly in the ointment" and that while it was hard to pinpoint at what level they would turn into a serious threat, $50 a barrel would certainly pose a "problem." "It creates a great dilemma because it slows growth and it also aggravates inflation and there is no good policy answer as to what to do," he said. Economist Allen Sinai of Decision Economics Inc. in Boston said the Fed's decision to put a brave face on economic prospects represented a big wager by policymakers that the impact of rising energy prices will soon fade. ENERGY A WILD CARD "The economy is fine, ex-energy, is how I would put it," Sinai said, though he noted that the Fed was likely not pleased by the divergent trends it now was seeing between rates of overall economic growth and prices. Gross domestic product slowed to a 3 percent rate of advance in the second quarter from a 4-1/2 percent rate in the first, and Sinai predicted it would come in around 2-1/4 to 3-1/4 percent in the third quarter. Meanwhile, prices have been on the rise. "That represents a risk to the outlook for the economy that's called stagflation," he said. "We're already observing slower rates of growth than had been expected and there is some suspicion that higher energy prices may be starting to bleed into core prices." Further complicating the matter are surveys that show some companies beginning to regain the ability to raise prices at the same time that the government is running a "loose" budget with large deficits. "What it means is that the possibility for higher oil and energy prices to reverberate throughout the economy and to weaken it are greater," Sinai said. "Once higher energy prices get embedded in the system, it isn't easy to get them out."
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