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Fed holds rates steady despite volatile markets

The Federal Reserve left a key interest rate unchanged on Tuesday as worries about inflation trumped concerns about turbulent financial markets.
/ Source: The Associated Press

Borrowers looking for some interest rate relief will have to keep on waiting.

Although Federal Reserve policymakers held interest rates steady Tuesday, they gave themselves some wiggle room for a cut down the road should economic conditions take a turn for the worse.

“Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses and the housing correction is ongoing,” said the Fed, its first acknowledgment of the recent conditions that have shaken Wall Street and Main Street. “Downside risks to growth have increased somewhat.”

The Fed did throw “investors a bone,” one analyst said, even though it stopped well short of saying a rate cut was imminent.

Fed Chairman Ben Bernanke and his central bank colleagues expressed hope that the economy will safely make its way. The policymakers also clung to their belief that the biggest potential danger to the economy is that inflation won’t recede as they anticipate.

Against these economic crosscurrents, the Fed left an important interest rate at 5.25 percent on Tuesday. In turn, commercial banks’ prime interest rate for certain credit cards, home equity lines of credit and other loans — would stay at 8.25 percent.

The central bank’s key rate hasn’t budged for more than a year. Before that, the Fed had raised rates for two years to fend off inflation.

On Wall Street, investors bid stocks higher. The Dow Jones industrials gained 35.52 points to close at 13,504.30.

Analysts believe the Fed probably will leave rates alone at its next meeting on Sept. 18. However, economists and investors now think the odds are growing that the Fed might lower rates by the end of this year — if the economy shows signs of faltering and if inflation isn’t worrisome.

For now, the Fed stuck to a forecast that the economy is likely to expand at a moderate pace in coming quarters. They also said they expected “solid growth in employment and incomes” — vital ingredients to the country’s economic health.

The Fed “didn’t completely satisfy investors but they did throw investors a bone,” said Mark Zandi, chief economist at Moody’s Economy.com. “They indicated that if things continue to weaken in financial markets, they will respond.”

The Fed was faced with a delicate dance, analysts said. To maintain credibility, it needed to acknowledge recent market gyrations, fears about a worsening housing slump and worries about a spreading and painful credit crunch. At the same time, it needed to send a comforting message but not be viewed as overly optimistic or pessimistic.

“They acknowledged and rightly so, the elephant in the room — problems in the credit market. But they didn’t feed it any peanuts by cutting rates,” said Stuart Hoffman, chief economist at PNC Financial Services Group. “But the statement gives the Fed a little more flexibility — a crack in the door — for them to cut rates later on” if the economy loses traction, he said.

The meltdown in the housing and mortgage markets has caused home foreclosures to climb to record highs and has forced some lenders out of business. Fears that credit problems will infect the broader financial system and the economy have fed market turbulence over recent weeks.

The free flow of credit is important to the smooth functioning of the national economy. Increasingly restrictive lending conditions can put a damper on peoples’ ability to buy big-ticket items such as homes, cars and appliances. And it can crimp businesses’ capital investment and hiring. That reduced appetite by businesses and consumers would slow overall economic activity.

“People on Wall Street have been undergoing tidal waves,” said Bill Cheney, chief economist at John Hancock Financial Services. “The Fed could hardly ignore that ... but I don’t think the Fed’s view of the economy has changed materially. The Fed statement seemed designed to reassure and to calm,” he added.

On inflation, the Fed policymakers again noted improvements. But they indicated they would need to see a steady string of better readings before they would downgrade their inflation risk.

Gasoline prices receded in early August but remain past $3 a gallon in some cities.

Meanwhile, core inflation — excluding food and energy prices — has moderated. These prices rose 1.9 percent over the 12 months ending in June, down from a 2 percent annual gain for May.

A government report Tuesday showed productivity got a lot stronger in the second quarter, helping to restrain the growth of employers’ labor costs. Analysts, however, believe the improvements on both fronts might be short-lived.

After nearly stalling in the first quarter of this year, economic growth rebounded in the April-to-June period at a solid 3.4 percent pace. That bounceback came despite a drag on economic activity from the sour housing market and a much smaller appetite by consumers to spend. Growth through the rest of the year is expected to be slower.

Given that, the nation’s unemployment rate — at 4.6 percent in July — is expected to climb close to 5 percent by year’s end, analysts say.

Full text of the Fed statement
Following is the full text of the Fed's statement:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.

Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Michael H. Moskow; William Poole; Eric Rosengren; and Kevin M. Warsh.