By John W. Schoen Senior producer
updated 9/20/2006 2:59:02 PM ET 2006-09-20T18:59:02

Federal Reserve policymakers left interest rates unchanged Wednesday for a second straight meeting, as a sharp drop in oil prices helped ease inflation concerns.

The central bank left the benchmark overnight lending rate at 5.25 percent, exactly where it has been since June 29, when the Fed halted a two-year stretch of 17 consecutive rate hikes.

The long rate-hike campaign was intended to keep the economy from overheating and sparking a damaging run-up in inflation. But with the economy showing clear signs of slowing, and energy prices plummeting, Fed Chairman Ben Bernanke and his colleagues have gotten some major breathing room in their effort to keep inflation contained.

Traders and analysts looked for some insight into the Fed’s next move by reading the tea leaves of the Fed’s comments on Wednesday’s decision.

“The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market,” the Fed’s Open Market Committee said in its statement.

The group cautioned that “some inflation risks remain,” noting that “readings on core inflation have been elevated, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures.”

But it said that “inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.”

As for future rate changes, the FOMC said the “extent and timing” of those moves “will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”

One member of the Fed's policymaking panel, Jeffrey Lacker, disagreed with the decision, voting instead for another quarter-point increase in the federal funds rate.

As short-term rates have risen, rates on loans to consumers and businesses -- including mortgage rates -- have followed suit. The overnight rate hit a 46-year low of 1 percent in 2003, sending mortgage rates to their lowest levels in decades and helping to fuel the boom in real estate.

But as mortgage rates have moved higher, the housing boom has cooled rapidly, raising concern about a potential ripple effect that could slow the economy's growth. On Tuesday, the Commerce Department reported that construction of new homes fell 6 percent in August, a much bigger decline than analysts had been expecting. Building permits hit their lowest level in nearly four years, a sign that the slowdown will continue in the months ahead.

Major Market Indices

A steep drop in energy prices has helped offset the hit taken by the housing sector. With oil prices down 20 percent since mid-July and pump prices down 15 percent and falling, fears have rapidly dissipated that high energy prices could touch off another 1970s-style round of inflation. If the recent drop in energy prices holds, Fed watchers say interest rates have likely peaked for now.

“It gives the Fed more reason to stand pat (on rates) beyond the September meeting into the meetings in the final three months of the year,” said Stuart Hoffman, chief economist at PNC Financial.

There’s already ample evidence that inflation is slowing. Prices at the wholesale level edged up just 0.1 percent in August, as a big drop in gasoline prices helped offset a jump in food costs. And the "core" wholesale inflation rate — which excludes food and energy prices because they bounce around so much — fell by 0.4 percent after a 0.3 percent drop in July. A report last week showed that inflation at the consumer level was up just 0.2 percent in August.

The stock market has also been rallying on increased confidence that the U.S. economy will enjoy a successful "soft landing," rather than a more painful recession. Broad indexes including the Dow Jones industrial average are near their highest levels since the bull market peak of early 2000.

After a strong showing of a 5.6 percent annual growth rate in the first quarter, the economy slowed to just a 2.9 percent pace in the second. Economists look for even slower growth over the second half of the year.  A Reuters poll of 69 economists released Monday found a median prediction of a one in four chance of the U.S. economy slipping into recession next year.

Saving billions at the pump
With energy prices falling, consumers are getting immediate inflation relief at the pump. After peaking just over $3 a gallon in mid-July, gasoline prices have fallen to an average of about $2.60 as of last week — with further prices drops expected. In some parts of the country, pump prices have fallen back through the $2-a-gallon mark.

Energy analyst Peter Beutel estimates that consumers save about $3.8 million a day for every penny knocked off the price of a gallon of gasoline. That means consumers have saved billions of dollars from falling pump prices in the past month.

A sustained drop in energy prices could also take price pressure off airlines, shippers and other transportation companies that have been passing along their higher fuel costs to consumers.

“With the housing sector now in a recession, with the inflation scare largely over, there's no reason at all for the Fed to raise rates,” Morgan Stanley chief economist Stephen Roach told CNBC Monday. “They’ll certainly stand pat and they'll continue to do that, and I think there's good chance they'll be talking about easing (rates) in early '07.”

But some economists say it's too early to begin looking for the Fed to cut rates. Former San Francisco Fed governor Robert Parry is among those who believe the rate-setting committee thinks inflation rates are still too high.

“I think there's a tightening bias for a very good reason,” he told CNBC shortly after the Fed’s annoucement. “If you look where inflation rates are and have been, they've been outside the range of what the Fed is thought to have as its tolerance area. ... I think it's very valuable for them to make it perfectly clear that they have their eye on inflation and know that it isn't where they'd like it to be.”

Higher energy prices have been just one of several factors pushing prices higher. After years of price-cutting made possible by lower manufacturing costs overseas, prices of imported goods have begun rising — thanks to a drop in the value of the dollar.

“Import prices were falling from 1995 to 2001 and early 2002,” said David Huether, chief economist at the National Association of Manufacturers. “When the dollar started coming down, within a quarter or so you saw prices of imports start to pick up. They’re not deflationary any more.”

Even if energy prices remain at lower levels – and that’s a big “if” – the folks at the Fed pay closest attention to the so-called “core” inflation rate - the statistic that excludes food and energy prices because they are subject to big, sudden ups and downs.

“(Core) inflation is already above the top of the Fed’s target,” said Hoffman. “Right now, they’re being patient. But it’s not like it’s been is at the lower end of the range and is starting to accelerate. It’s already gone through the presumed 2.0 to 2.5 percent threshold.”

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