Fed Holds Rate Amid Growth, Inflation Concerns

Target Stays At 2%

Following 10-1 Vote;

Optimism Is Faint

By SUDEEP REDDY

Wall Street Journal

August 6, 2008; Page A3

The Federal Reserve left interest rates unchanged as it remains stuck between worries about rising prices and renewed concerns about slower growth.

"Although downside risks to growth remain, the upside risks to inflation are also of significant concern," the Fed said in announcing its decision to leave its target for the federal funds rate, charged on overnight loans between banks, at 2%.

The vote for the rate decision was 10-1. Federal Reserve Bank of Dallas President Richard Fisher cast his fifth dissent of the year, preferring a rate increase. Voting with the majority was Elizabeth Duke, a former banker who was sworn in Tuesday morning as a Fed governor.

The Fed's announcement, offering a more balanced view of growth and inflation risks than it did in June, helped extend a rally in stocks, as investors concluded that a rate increase is not likely soon. The Dow Jones Industrial Average gained 331.62 to close at 11615.77.

The central bank's policy committee noted that the economy expanded in the second quarter partly on export growth and stronger consumer spending. But those supports are at risk. The Fed said labor markets "have softened further" -- a nod to the rising unemployment rate -- and financial markets "remain under considerable stress."

In June, the Fed sounded a faint tone of optimism about economic growth, saying risks "appear to have diminished somewhat." Its latest statement removed that language and reiterated warnings that the weak housing market, tight credit and high energy prices are likely to weigh on growth.

While the statement called the inflation outlook "highly uncertain," the easing of energy prices supports the Fed's expectation, stated in June and again Tuesday, that inflation would moderate this year and next year. The benchmark crude-oil futures contract closed at $119.17 a barrel, its lowest level in three months.

"The drop in energy prices takes a lot of pressure off them," Morgan Stanley economist David Greenlaw said. "But they're going to keep talking tough on inflation. That's the central bank's job when inflation expectations have risen."

Many analysts do not foresee a rate increase until next year. That outlook is based largely on the credit crisis, which threatens to exact a deeper toll on the economy. The Fed cut interest rates aggressively over the past year -- from 5.25% last September -- and introduced direct-loan programs for financial institutions. The moves have only partially improved conditions in lending markets.

Rates for a 30-year-fixed mortgage are higher than they were a year ago, as banks tighten standards and lenders Fannie Mae and Freddie Mac struggle. Banks are facing steep losses from mortgages, so they have less capital for new lending.

As people find it tougher to get a mortgage, and pay more when they do, that threatens to exacerbate the housing downturn, which in turn could restrain consumer spending.

The U.S. economy expanded at a 1.9% annual rate in the second quarter largely because of surging exports. But growth is slowing abroad, threatening the market for U.S. products.

Consumers got a boost this year from $90 billion in stimulus checks, but that impact is fading. The unemployment rate stands at 5.7%, a four-year high.

The consumer price index rose 5% in June from a year earlier, a 17-year high. The Fed's preferred gauge (the price index for personal consumption expenditures) rose 4.1%. Excluding food and energy, prices rose 2.3% in June compared to a year earlier. That's above the 1.5% to 2% range Fed officials consider price stability.

The key quandary facing the Fed: Will inflation moderate quickly enough to give policy makers breathing room to raise rates more slowly, as most officials prefer? Or will they be forced to respond to inflation concerns sooner?

"There's a lot that's weighing on the economy, in particular on consumers, the financial sector and the housing sector," said Peter Hooper, chief economist at Deutsche Bank Securities. To make their next move on interest rates, Fed officials would need to see "either enough improvement in the financial markets and economic indicators to allow them to raise rates as they would like to, or enough worsening on the inflation front to force them to do so."

Some Fed officials fear high prices are already sending consumer and business expectations for inflation too high, threatening a price spiral that would be difficult to rein in. Most officials, however, believe the slower economy, through lower demand for goods and a weaker job market, will keep prices and wages under control.

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