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Fed Again Stands Pat on Interest Rates

But the central bank holds out the possibility of future rate hikes to stave off inflation.

September 21, 2006|Joel Havemann | Times Staff Writer

WASHINGTON — The Federal Reserve on Wednesday left its benchmark short-term interest rate unchanged for a second consecutive meeting but held out the possibility that further rate hikes could be forthcoming to fight inflation.

The decision to hold at 5.25% was expected, but the central bank's hesitancy to suggest that its credit-tightening program was completely over sparked renewed debate about Fed policy and the state of the economy.

The financial markets and some analysts are betting that the Fed is done raising rates and might even start easing next year -- a view reinforced by recently falling energy prices and a sharp cooling of the housing market. They are hoping for a "soft landing" of sustainable growth with contained inflation and no recession.

But other analysts aren't so sure. They say inflation is still too high for comfort and more rate hikes might be needed. That view was shared by Fed member Jeffrey M. Lacker, an anti-inflation "hawk" who dissented with his colleagues Wednesday and voted to raise rates another quarter-point.

The statement by the Fed's policymaking Federal Open Market Committee explaining its decision to stand pat acknowledged that "inflation pressures seem likely to moderate over time" because of the slowing economy and previous rate boosts.

But "some inflation risks remain," the Fed said, and the need for further rate hikes "will depend on the evolution of the outlook for both inflation and economic growth."

The Fed committee used identical language Aug. 8 when it refrained for the first time since mid-2004 from raising short-term rates by 0.25 of a percentage point.

The campaign lifted the federal funds rate, the only one that the Fed controls directly, from 1% to 5.25% in 17 consecutive increases. The federal funds rate in turn influences many kinds of consumer loans and investments.

The Fed's action Wednesday came as a modest disappointment to some investors who had hoped for a signal that the campaign to raise interest rates might be over -- and that the next step might be to reduce rates in the interest of generating economic growth. The Dow Jones industrial average, which had been up about 80 points on the day, immediately gave back 30, although it gained most of that back before the close.

Many analysts said future Fed actions would depend on whether the major threat to the economy is judged to be a continued slowdown in growth or an additional uptick in inflation. Growth fell from a red-hot 5.6% annualized rate in the first three months of this year to a more sustainable 2.9% in the second. The government reported in the last week that inflation, thanks in part to falling oil prices, abated in August.

Particularly problematic is the housing market, which is falling fast in some parts of the country.

"This is a tough time for the Fed," said Ethan Harris, chief U.S. economist for Lehman Bros. Holdings Inc. "They have to balance the risk of a hard landing for the housing market against the risk that inflation continues to rise."

Former Fed Chairman Alan Greenspan, who retired this year, allowed the housing market to soar out of control by keeping interest rates at historically low levels for too long after the shock of the Sept. 11, 2001, terrorist attacks, Harris said.

Greenspan's successor, Ben S. Bernanke, "inherited his mistakes," Harris said.

A declining housing market could shave as much as 1 percentage point off economic growth, Harris said.

"People have been borrowing against the value of their homes and the construction industry has been booming. Together, these were fueling growth and now they're going in reverse," Harris said.

Unlike last month, Wednesday's Open Market Committee statement zeroed in on the housing market as the chief threat to economic growth, instead of targeting increasing interest rates and energy prices.

Harris predicted that the next move in interest rates would be upward. The housing market may show signs of hitting bottom by the end of the year, he said, but inflation will continue to creep upward.

"It's too early to declare victory over inflation," he said.

By contrast, interest rate futures markets show investors betting that the next move in rates will be downward.

Goldman Sachs Group Inc. told its clients that it saw rate cuts starting early next year, with the federal funds rate reaching 4% by the end of 2007.

Brian Bethune, U.S. economist at consulting firm Global Insight Inc., saw the federal funds rate holding steady for a full 12 months and declining to 4.75% by the end of next year.

Ian Shepherdson, chief U.S. economist for High Frequency Economics, carefully avoided predictions, observing only that "for now the Fed remains firmly in wait-and-see mode."

Wednesday's vote by the Open Market Committee to leave the federal funds rate unchanged was 10 to 1. As was the case in August, the only negative vote came from Lacker, president of the Federal Reserve Bank in Richmond, Va.

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joel.havemann@latimes.com

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