Growth doubts likely to increase

The Fed, however, has a dual mandate of maintaining price stability and the highest possible level of employment. It will, therefore, be placed in a very difficult situation if there is a rise in inflation at the same time as a deteriorating economy. The U.S. labor market remained strong in the third quarter and the unemployment level remained low at 5.1 percent.

There is still likely to be unease over the sustainability of consumer spending, especially as the savings rate is already at a very low level. In this environment, any negative income shock will quickly result in lower spending growth.

Retail sales rose 0.2 percent in September, a 1.1-percent increase excluding auto sales, but spending was inflated by the sharp rise in gasoline prices. Consumer confidence levels have continued to deteriorate, with little evidence of a recovery from the hurricane Katrina shock. Although confidence levels do not have a strong predictive track record for consumer spending trends, there will still be concern over underlying conditions, especially if high energy prices are sustained or employment growth slows.

In this context, the housing sector will remain very important for the U.S. economy and the currency. If prices hold firm there will be a much reduced risk of a drop in consumer spending. Conversely, any significant drop in prices would increase the threat to consumer spending. Overall, the risks to retail demand will increase, especially as rising long-term interest rates will push up mortgage rates.

There are, therefore, likely to be constraints on Fed tightening starting in early 2006.