Fed Ends String Of Rate Cuts

Central Bank Cites Heightened Fears About Inflation

The Federal Reserve left a key interest rate unchanged yesterday, ending a long campaign of interest rate cuts, as the central bank indicated that it was increasingly worried about inflation. But the Fed offered no sign that it was planning rate hikes in the near future to combat soaring prices.

By leaving the federal funds rate at 2 percent, the Fed was acknowledging that the economy has held up better than many of its leaders had forecast but that price increases have been much worse. The rate, at which banks lend to one another, affects consumer rates for an auto loans, credit cards or mortgages, and influences borrowing costs for businesses.

The risks of much weaker growth "appear to have diminished somewhat," the policymakers said in a statement, but the "upside risks of inflation and inflation expectations have increased." The policymakers, however, chose not to raise rates to fight that inflationary trend nor used language suggesting that rate increases were on the way.

"They're trying to buy time here," said Ethan Harris, chief U.S. economist of Lehman Brothers. "They know they're in an impossible box with the combination of rising inflation expectations and a very fragile economy, and they'd like to just sit back and let things calm down and wait as long as they can to act."

The non-action was widely anticipated, and financial markets rose following the afternoon announcement before falling back. The Dow Jones industrial average ended the day essentially unchanged, up 4.40 points, or 0.04 percent.

Yesterday marked the end of the most aggressive rate-cutting campaign in the modern history of the Federal Reserve; beginning in September, the central bank slashed rates at six straight meetings and once between meetings, driving the rate from 5.25 to 2 percent. The idea was to stop the financial crisis that began in the market for subprime mortgages from spiraling into a deep and prolonged recession.

Sure enough, the economy is in only a modest downturn, with economic growth still slightly positive and fewer jobs being shed than in recent recessions. But in the meantime, prices for oil and other commodities have soared on world markets, pushing up costs for a broad range of items that U.S. consumers buy.

Yesterday's statement from the Federal Open Market Committee, the Fed's policymaking group, said that in light of continued increases in energy prices and the "elevated state" of Americans' expectations for inflation, "uncertainty about the inflation outlook remains high."

The statement, combined with recent comments by Fed Chairman Ben S. Bernanke and other top officials, was an attempt to convince markets that the Fed will be vigilant about fighting inflation without doing anything that might trigger more weakness in the economy.

"It's an open-mouth policy, and it's really their only option," said Richard Yamarone, chief economist of Argus Research. "They can't raise rates when the economy is this weak, so they're using words and finger-wagging to try to keep inflation expectations in line."

Or, as Wachovia economists titled their report on yesterday's actions, "Speak Loudly and Carry a Small Stick."

One member of the policymaking committee, Dallas Fed President Richard W. Fisher, dissented, saying he preferred to raise rates. There had also been at least one dissenter -- and sometimes two -- on the previous seven rate cuts. Fisher is part of a contingent of presidents of regional Federal Reserve banks who have been uneasy about the rapid rate cuts and prefer a more aggressive response to inflation.

But Bernanke and a majority of his Fed colleagues still view the economy as being in a sensitive and difficult stage, and are disinclined to raise rates this summer unless there are clear signs that Americans' expectations for future inflation are becoming unhinged. That would create the risk of a treacherous self-reinforcing cycle in which higher expected inflation breeds higher inflation, which happened in the 1970s.

The Fed is forecasting that prices for oil and other commodities will level off in the second half of the year, which is the expectation priced into futures markets. If that occurred, it would ease inflationary pressures. However, as Fed officials have acknowledged, futures markets have been incorrectly predicting a leveling off of those prices for years.

Prices in futures markets indicate a 68 percent chance that the Fed will not change rates at its next policymaking meeting Aug. 5, with a 32 percent chance of a rate increase.