Fed Keeps Key Rate Steady At 5.25%
Decision Follows Economic Slowdown

By Paul Blustein
Washington Post Staff Writer
Wednesday, August 9, 2006

The longest sustained campaign of interest-rate hikes in Federal Reserve history ended yesterday as the central bank left its benchmark rate unchanged, snapping a string of 17 consecutive increases.

The decision reflected a belief by Fed policymakers that the economy is slowing sharply and may continue to do so in coming months -- enough, the Fed hopes, to quell an upsurge of inflation.

The central bank warned that it was ready to increase the rate again if inflation went higher. But keeping the rate steady yesterday could be a major turning point in the economy after a relentless upward march in the federal funds rate, the short-term interest rate that the Fed directly controls.

Since June 2004, when the rate was at a four-decade low of 1 percent, the policy-setting Federal Open Market Committee has lifted it 17 times by one-quarter of a percentage point at each of its meetings. The rate, which is 5.25 percent, indirectly affects many other interest rates.

"There's an end in sight," said Peter Hooper, chief U.S. economist at Deutsche Bank Securities Inc. and a former Fed economist. "If growth has slowed enough now for the Fed to stop raising rates, then mortgage rates don't have to go up much further, for instance. But there's some bad news here too'' -- that unemployment will have to rise if the Fed is to refrain from further increases.

If the job market is stronger than expected and wages continue going up rapidly, Hooper said, "we'll have to pay more in interest rates, to slow things down."

The Fed signaled that it wanted to assess the effects of its rate increases before tightening more. Typically, a rate increase takes a year or more before it is shown in the spending behavior of businesses and consumers.

"Economic growth has moderated from its quite strong pace earlier this year," the Fed said in a written statement. Although certain factors such as high energy costs may keep inflation rising, "inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors," the statement said.

Recent government statistics showing a marked cooling in the economy, stemming in part from the blow that higher interest has dealt to the once red-hot housing industry. The latest evidence came Friday in a report showing that the unemployment rate edged up to 4.8 percent in July, from 4.6 percent in June, while the growth in payrolls for the month was a relatively sluggish 113,000.

Some economists are worried that in its zeal to contain inflation, the Fed may have tipped the economy toward recession. Concern about excessively raising interest rates was clearly on the minds of Fed policymakers yesterday; Janet L. Yellen, president of the Federal Reserve Bank of San Francisco, warned recently that "if we kept automatically raising rates until we saw inflation start to respond, we most likely would have gone too far."

The opposite risk is that the buildup in inflationary pressures will prove so great that in pausing now, the Fed will only have to raise rates more drastically later. Labor costs have mounted in recent months, aggravating worries that inflationary pressures are more deeply rooted than the single problem of rising oil and gas prices.

A Labor Department report yesterday said labor costs for each unit of output rose at an annual rate of 4.2 percent in the second quarter, up from 2.5 percent in the first three months of the year.

Among the most prominent economists voicing such concerns was Martin S. Feldstein, a Harvard University professor, who in a Wall Street Journal article on Monday warned that the Fed's goal of a "soft landing," with low inflation and solid growth, may be impossible. "If the Fed wants to convince the markets that inflation will be contained in the future, it must show that it is willing to take the risk of tightening too much," Feldstein wrote.

One of the 12 members of the Federal Open Market Committee took a similar view yesterday. Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, voted against the decision to keep rates steady, the first dissent since a committee meeting last October. He wanted another quarter-percentage-point increase.

Seeking to assuage fears that it will relax its guard, the Fed said in its statement that "some inflation risks remain. The extent and timing of any additional [rate increases] that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

That statement "left the door open to another hike, and I think the inflation data will push them through that door," said Ethan S. Harris, chief U.S. economist at Lehman Brothers Inc.

"They're in a very tight bind," he said. "They've got a weak economy on one hand, and creeping inflation on the other. It must have been a close call at the meeting today. If I were at the Fed, I might have voted with Mr. Lacker for a rate hike, but I can understand why they have decided to pause."

Financial markets, which had anticipated the Fed's decision, gyrated a bit after it was announced at 2:15 p.m. The Dow Jones industrial average rose at first but then fell, closing down 45.79 points, to 11,173.59.

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