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Fed holds steady on rates

August 08, 2007|Peter G. Gosselin | Times Staff Writer

WASHINGTON — The Federal Reserve on Tuesday left interest rates unchanged but suggested for the first time that turmoil in financial markets, a widening credit crunch and the continuing housing downturn could further slow an already decelerating economy.

But analysts said the Fed set the stage for a possible change of course in the months ahead if a credit crunch and continuing upheavals in financial markets threatened to hurt the overall economy.

Beginning in mid-2004 the central bank raised its benchmark short-term interest rate for two years and, for the last 13 months, has held it steady at 5.25%. The Fed has said that rising inflation is a bigger concern than slowing growth.

Though few analysts expected the Fed to try to offset the current market turmoil by lowering its key rate Tuesday, some had hoped that policymakers would at least signal that they were preparing for such a step.

Instead, the central bank took official notice of the problems and said, in effect, that it would pause and consider whether its focus on avoiding inflation needed to change.

"The balance of risks is shifting," said Richard Berner, chief U.S. economist with Morgan Stanley in New York. "But it hasn't shifted to the point where the Fed feels it has to act, or even change its rhetoric."

In its statement announcing the decision to leave interest rates unchanged, the Fed said, "Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing."

"Nevertheless," it said, "the economy seems likely to continue to expand at a moderate pace over the coming quarters, supported by solid growth in employment and a robust global economy."

Fed Chairman Ben S. Bernanke has repeatedly said he did not believe the current problems in the housing and credit markets were serious enough to cause a sharp slowdown in the overall U.S. economy. He has suggested that he did not want to get into the position that some said his predecessor, Alan Greenspan, did of riding to the rescue whenever a market got seriously out of kilter.

"There's a very big contrast between the Bernanke Fed and the Greenspan Fed," said Denver-based economic consultant David M. Jones, a veteran watcher of the central bank. "Greenspan was quite sensitive to market developments and he was always there when they needed him."

Greenspan moved rapidly to respond to the 1987 stock crash, the 1998 collapse of hedge fund Long-Term Capital Management and the 2001 terror attacks that temporarily shut the financial markets. He developed a technique of flooding the economy with money and cutting interest rates to offset the effect of such sudden blows, then slowly undoing his handiwork after the crisis had passed and economic conditions leveled out.

By contrast, the Bernanke-led central bank seems relatively unconcerned about market upheavals.

"They don't feel it's their responsibility to come to the aid of the market when it gets in trouble," Jones said of the new crop of Fed policymakers.

"There is very much of an academic tenor" to the Fed, Jones said. "The academic view is that you stick to your monetary knitting and are relatively oblivious to market developments."

Critics of Greenspan's technique said it increased the danger of problems because market players got complacent about the risks they took, knowing they could count on the Fed to jump in if trouble developed.

On the flip side, Bernanke's defenders said it was not clear that the current problems in low-end home mortgages and other upheavals posed as much of a threat to the economy as an event such as the 1987 crash.

In a statement after each of its policy meetings, the central bank declares what it considers the biggest threat to the economy. Before Tuesday's announcement, some observers had hoped the Fed would change its position and say the threats of inflation and slower growth were now equally balanced.

But the central bank stuck to its guns and declared that the biggest threat remained higher prices. The Fed's "predominant policy concern remains the risk that inflation will fail to moderate as expected," the statement said.

The central bank said inflation as measured by its favored method, which excludes volatile food and energy prices, had "improved modestly in recent months." But the Fed added that "a sustained moderation in inflation pressures has yet to be convincingly demonstrated."

The statement, however, did say the "downside risks to growth have increased somewhat."

The unanimous decision of the Fed's policymaking body leaves the benchmark federal funds rate, the rate at which banks make short-term loans to each other, at 5.25%, where it has been since June of last year.

In essence, the Fed appears to be treading water while it sees whether the housing contraction, the sub-prime mortgage mess and the volatile stock market spill over to the larger economy and cause it to slow more than expected.

Analysts said that if new statistics showed weak retail sales, a slowdown in manufacturing and service sector activity and a falloff in hiring, the Fed could change its official focus at its next meeting Sept. 18 and might actually begin cutting rates before the end of the year.

peter.gosselin@latimes.com

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