Federal Reserve Holds Rates Steady at 2.00%, Says "Downside Risks" and Inflation Remain Concerns

By Jason Simpkins
Associate Editor

Federal Reserve policymakers yesterday (Tuesday) kept the nation's benchmark interest rate at 2.00% for the second consecutive meeting, although inflation accelerated and the U.S. economy only advanced slowly.

"Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the committee," the policymaking Federal Open Market Committee (FOMC) said in a statement.

After a slight contraction in the fourth quarter of 2007, U.S. gross domestic product (GDP) has expanded at a moderate pace, enabling the U.S. economy to dodge an actual recession. GDP increased a 1.9% annual rate in the second quarter after edging up 0.9% in the first quarter. Consumer spending, which accounts for about 70% of GDP, rose 1.5% in the April-June period after a 0.9% jump in the first quarter.

However, those gains were largely the result of the $112.4 million in stimulus payments sent out this spring, and analysts wonder if spending will hold up under as unemployment continues to rise and high prices stretch household budgets.

"My view is that the Fed is on hold at least through the fall and likely" even longer than that, said Joel L. Naroff, president and chief economist of Naroff Economic Advisors Inc. in Holland, Pa. "The worries about inflation notwithstanding, the FOMC still started with a discussion of the economy the comments were not particularly sanguine. The committee is likely to need some hard data that conditions are getting better before they start to unwind the rate cuts. With payroll declines continuing, it is hard right now to see how that could happen by year's end."

The Fed began its historic rate-cutting campaign on Sept. 18, when it slashed the Fed Funds rate by half a percentage point, bringing it down to 4.75%. That ignited the biggest one-day stock-market gain in five years, with the Dow Jones Industrial Average soaring 336 points to close at 13,739.39.

The 30-stock blue-chip index soared 331.62 points yesterday to close at 11,615.77. At that level, the Dow is down 19% from its high-water mark of last year - technically just outside the 20% boundary that denotes an official "bear market."

The U.S. unemployment rate hit 5.7% in July - its highest level in four years. 

"Labor markets have softened further and financial markets remain under considerable stress," the Fed's statement said. "Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters."

With jobs clearly being "a central concern," Naroff said investors should "watch the employment data carefully. A reappearance of job gains could change the outlook quickly."

Of course, inflation has risen to its highest level in 17 years, led by higher food and energy costs, leaving the Fed with little or no room to cut rates if the economy does falter. The U.S. Federal Reserve's preferred gauge of inflation rose at a 2.1% pace in the second quarter, down only modestly from 2.3% in the three prior months.

"Inflation has been high, spurred by earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated," the Fed said.

Inflation is already putting the squeeze on the American consumer. In current dollars, consumer spending rose 0.6% in June. But after adjusting for inflation, spending actually dropped 0.2%. The development is a harsh indication that U.S. shoppers are paying more to get less.

Dallas Fed President Richard Fisher was the only dissenting opinion in a 10-1 vote to leave hold rates steady, preferring instead to raise rates immediately. Fisher is widely regarded by Fed watchers as the most hawkish of the current Fed policy committee members.

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