Amid widening financial chaos, Fed holds rates

/ Source: The Associated Press

Showing a tough love stance for now, Federal Reserve Chairman Ben Bernanke and his colleagues decided to keep a key interest rate steady Tuesday. They acknowledged stresses in financial markets have grown, though, and hinted they stood ready to lower rates if needed.

Wreckage on Wall Street in recent days did not force the Fed — as some thought possible — to reverse course and cut rates. The Fed left its key rate at 2 percent for the third straight meeting. It marked the first meeting this year the Federal Open Market Committee, which sets interest rate policy, agreed unanimously with a decision.

The prime lending rate for millions of consumers and businesses stayed at 5 percent. The prime rate applies to certain credit cards, home equity lines of credit and other loans. The Fed’s key rate and the prime rate are at four-year lows.

The Fed’s view of economic and financial conditions, however, was more dour than its last assessment in early August. Economic growth appears to be slowing as consumers hunker down and export growth cools off a bit, Fed policymakers said. And, “strains in financial markets have increased significantly,” the Fed said.

The more bearish tone indicates the Fed is again open to rate cuts down the road, some analysts believe.

“The Fed has opened the door to a rate cut that many thought was closed,” said Stuart Hoffman, chief economist at PNC Financial Services Group. “I think there was more emphasis about the economy being weak.”

The Fed said it would “act as needed.”

In recent days, the American financial system has suffered its worst shakeout since the Great Depression as bad bets on dodgy mortgage-backed securities claimed more Wall Street giants.

Lehman Brothers, the country’s fourth-largest investment bank, filed for bankruptcy protection. A weakened Merrill Lynch, deciding it couldn’t go it alone anymore, found help in the arms of Bank of America. Now, the insurance giant American International Group is dangerously wobbling. Against this backdrop, Wall Street on Monday plunged 500 points, the most since the September 2001 terror attacks.

On Tuesday, the Dow Jones industrials gained 141 points after the Fed’s action soothed market anxiety over the financial system.

So far this year, 11 federally insured banks and thrifts have failed, compared with three last year. The country’s largest thrift, Washington Mutual Inc., is faltering.

Urgently trying to keep cash flowing amid a Wall Street meltdown, the Fed pumped another $70 billion into the nation’s financial system to help ease credit stresses. In emergency sessions over the weekend, the Fed expanded its loan programs to Wall Street firms, part of an ongoing effort to get credit flowing more freely.

By standing pat now, the Fed is leaving room in its rate-cutting arsenal to act later, if needed. “The Fed has kept its powder dry,” said Terry Connelly, dean of Golden Gate University’s Ageno School of Business.

Over the last few months, Bernanke and his Fed colleagues have signaled that the central bank’s next move on interest rates would probably be an increase to fend off inflation. Given all the economic and financial problems, though, economists are now saying the likelihood of a rate increase over the next six to nine months has all but disappeared.

Inflation — which has been high — should moderate later this year and next year, the Fed said. It dropped language contained in its August assessment that some barometers of consumer and business expectations of inflation have been “elevated.” That suggested slightly less concern about inflation even as the Fed made clear it would remain vigilant on this front.

The Fed in June halted its most aggressive rate-cutting campaign to shore up the economy out of fears that those low rates were aggravating inflation. It didn’t budge the rate at the last meeting in August for the same reason.

One of the most closely watched inflation yardsticks — consumer prices— registered the first monthly drop in nearly two years, giving some relief to stresses consumers, the government reported Tuesday. The improvement came from moderating energy prices, which hit record highs in mid July. That gives the Fed more leeway to lower rates if needed or at least to hold them steady.

Fed officials have suggested that harder-to-get credit and financial troubles have blunted the energizing impact of the central bank’s already-ordered rate cuts on consumers and businesses. Economic growth is slowing and the unemployment rate is at a five-year high of 6.1 percent.

Given that, some argued that an additional rate cut probably wouldn’t do much to turn around worried consumers and bolster the economy. Others feared another rate cut could send a wrong message to financial companies that made bad bets.

“The Fed left the rate unchanged because that was the right thing to do. The Fed can lower interest rates, but is (that) going to revive this ailing financial system? I don’t think so. I think we’re beyond the point were the Fed can do much about this,” said Timothy A. Canova, professor of international economic law at the Chapman University School of Law in Orange, Calif.

Fallout from the crisis is prompting Democrats to call for a second round of government stimulus, something Republicans and President Bush so far has resisted. And, on the campaign trail, both presidential GOP nominee Sen. John McCain and his Democratic rival, Sen. Barack Obama, said the cascading crisis underscores the need to overhaul the nation’s regulatory structure, which dates back to the Civil War.

Full text of Fed statement
Following is the full text of the statement issued Tuesday by the Federal Reserve:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner.