US Federal Reserve Holds Rates Steady

The Federal Reserve, navigating treacherous economic waters, decided on Wednesday to leave a key interest rate unchanged, bringing an end to a string of consecutive rate cuts. The decision to leave rates unchanged had been widely expected by financial markets.The central bank announced that it was keeping the federal funds rate, the interest rate that banks charge each other, at 2 per cent, marking the first time in 10 months that the central bank has failed to reduce interest rates at one of its regular meetings.

The Fed is confronted with the twin perils of a possible recession and rising inflation pressures, stemming from this year's surge in oil and food prices.

In a brief statement explaining the decision, 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. The statement said that the downside risks to growth “appear to have diminished somewhat” while adding that “the upside risks to inflation and inflation expectations have increased.

Because of the Fed's decision, 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 per cent, its lowest level since late 2004.

Investors are split about the Fed's actions for the rest of the year. Some analysts believe the Fed could start raising rates, possibly as soon as the next meeting in August because of concerns about inflation. Other economists argue that the weak economy and rising unemployment will keep the Fed on the sidelines until at least after the November elections.

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.

The Bush administration is hoping that the government's $168-billion (U.S.) economic stimulus program, which is sending rebate payments to 130 million households, will help dissolve some of the gloom and bolster consumer spending in the months ahead.

Other analysts, however, said they believed Mr.Bernanke wanted to send out a strong anti-inflation warning, especially since it was coupled with a comment in an earlier speech about the Fed chief's concerns that the weak U.S. dollar was adding to U.S. inflation problems. The remarks taken together had the impact of bolstering the dollar, which had been tumbling.
The Fed is making an effort to convince the markets that the central bank is serious about fighting inflation without having to start raising interest rates at a time when the economy remains very weak.

The last thing the central bank wants is a repeat of the 1970s, when successive oil price shocks did trigger a wage-price spiral that sent inflation soaring and was only subdued when the Fed under Paul Volcker pushed interest rates to levels not seen since the Civil War.

Rocky times are ahead and investors must use prudence and care to successfully navigate through them.

Warmly,

Mary Wozny