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Key Rate Holds Steady At 2%; Inflation Risks Have Increased

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The Associated Press

Published: June 26, 2008

WASHINGTON - The Federal Reserve decided on Wednesday to leave a key interest rate unchanged and cited a heightened risk of inflation, which could lead to rate increases down the road. Private analysts said the Fed might delay the first rate increase until December.

The central bank announced that it was keeping the federal funds rate - the interest rate that banks charge each other - at 2 percent. It marked the first time in 10 months that the central bank has failed to reduce interest rates at one of its regular meetings.

In a brief statement, Fed Chairman Ben Bernanke and his colleagues cited both the threats to growth and rising inflation pressures as problems confronting the economy at the moment. They said the downside risks to growth "appear to have diminished somewhat" while adding that "the upside risks to inflation and inflation expectations have increased."

The Fed action was approved on a 9-1 vote with Richard Fisher, president of the Fed's regional bank in Dallas, casting a dissenting vote. Fisher objected to the action, saying he would have preferred an immediate increase in interest rates to fight inflation.

The decision to leave rates unchanged had been widely expected by financial markets. The Dow Jones industrial average staged a brief rally but then returned to around the level it had been just before the announcement.

No 'Urgency' Seen

Economists said they thought Fed policymakers were seeking to assure markets that although they are watching inflation carefully, they do not feel an immediate need to start raising rates.

"They reaffirmed that there will be no further rate cuts and the next change will be a rate increase, but I didn't see any special urgency about how soon that rate increase will take place," said David Jones, chief economist at DMJ Advisors.

Jones said that based on this statement it is likely that the Fed will keep rates unchanged until the December meeting, while other analysts said they were not looking for any rate changes at least until the fall.

"When push comes to shove, we still expect Mr. Bernanke, student of the Depression, to prevail and keep rates on hold through the summer," said Ian Shepherdson, chief U.S. economist at High Frequency Economics.

Fed's Tools Limited

Because of the Fed's decision Wednesday, short-term borrowing costs on millions of consumer and business loans tied to banks' prime lending rate will remain unchanged. The prime rate is currently at 5 percent, its lowest level since late 2004.

While saying that the upside risks to inflation have increased, the central bank repeated its forecast that it expected "inflation to moderate later this year and next year."

The opposing forces of weak growth and recession put the central bank in a bind. Its main policy tool - changes in interest rates - can only address one of those problems at a time. The Fed can cut interest rates to spur consumer and business spending and economic growth or it can raise interest rates to slow spending and growth and ease inflation pressures.

From September through April, the Fed aggressively cut interest rates seven times. However, after a series of sizable rate cuts as the credit crisis was roiling global financial markets at the beginning of this year, the Fed at its last meeting in April reduced rates by a more modest quarter-point and signaled that the rate cuts could be coming to an end.

Even as Fed policymakers were meeting Tuesday and Wednesday, the economic news has continued to be bleak, including a report showing that consumer confidence in June dropped to the lowest level in 16 years. Soaring gasoline prices, plunging home values and rising unemployment are all weighing on confidence.

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