Fed Holds Steady On Key Rate

Bank Keeps Close Eye on Inflation

Federal Reserve policymakers held short-term interest rates steady yesterday, saying inflation remains too high but should drift lower as energy prices fall and the economy slows.

The central bank left open the door to further rate increases if necessary to tamp down price pressures, but the decision strengthened many analysts' view that the Fed is done increasing rates for now.

The policymaking Federal Open Market Committee last raised its benchmark short-term interest rate to 5.25 percent in June, the 17th consecutive increase in two years meant to cool the economy and bring down inflation. The group left the rate unchanged at its previous meeting, in early August, saying that it expected price pressures to weaken as past rate increases took effect in coming months.

Since then, energy prices have tumbled, inflation has ebbed and the housing market has slowed sharply, boosting expectations in financial markets that the central bank will leave interest rates on hold through the end of the year, and perhaps even cut rates early next year.

One big question for the committee and financial markets now is how the housing downturn will affect the rest of the economy.

The housing boom of recent years was a big generator of jobs in construction, finance and retailing, and rapid appreciation of housing prices encouraged many consumers to borrow against their homes to finance extra spending.

Construction of new homes plunged 6 percent in August, for the third consecutive monthly decline, pushing the pace of home building to its lowest level in more than three years. Inventories of unsold homes have shot up in recent months, and the rise of home prices has been sluggish.

This shift is likely to cause a "fairly significant" drop in consumer spending and a hit to the economy next year, which will prompt the Fed to cut interest rates by the spring, predicted Jan Hatzius, chief economist at Goldman Sachs Group Inc.

But other economists, including many at the Fed, believe the weakness in housing will be offset by strong business investment, an increase in exports and solid consumer spending. Many households have more money to spend now than earlier this year because of lower gasoline prices, rising incomes and steady job growth.

"Housing is going to cool off, but not crush the economy," said Ethan S. Harris, chief U.S. economist at Lehman Brothers Holdings Inc. He added that though inflation had eased, it will remain high for several months, likely prompting the Fed to raise its benchmark interest rate to 5.5 percent this year and perhaps to 5.75 percent early next year.

The Fed adjusts interest rates to encourage economic growth and keep inflation low. Higher rates make it harder for businesses and consumers to borrow and spend, slowing growth and weakening inflation. Lower rates do the opposite.

Consumer prices rose 2.4 percent in the 12 months that ended in July, according to the Fed's preferred measure, which excludes volatile food and energy prices. That is above the 1 to 2 percent comfort zone described by Chairman Ben S. Bernanke and several of his colleagues.

As in August, one voting member of the Fed committee dissented yesterday from its decision. Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, would have preferred another quarter-percentage point increase in the benchmark interest rate, the group said in a statement.

Lacker has argued that the Fed should raise the rate to bring down inflation more rapidly.

The Fed's decision means that consumer interest rates linked to the benchmark federal funds rate should stay steady as well. Those include rates on many credit cards and home equity loans.

Fed policy directly affects short-term interest rates like those on credit cards, but only indirectly influences long-term rates, which are determined more by global financial markets. Mortgage rates, for example, have declined in recent months. The average rate on a 30-year, fixed-rate mortgage slipped to 6.43 percent last week, down from a peak this year of 6.79 percent in early July, according to mortgage financier Freddie Mac.

Financial markets showed little reaction to yesterday's decision, which traders had expected. The Dow Jones industrial average gained 72.28 points, or 0.63 percent, to close at 11,613.19.