Fed Holds Rates Despite Market Turmoil

Aug. 7, 2007 — -- The Federal Reserve this afternoon once again left a key interest rate unchanged.

The central bank noted that financial markets have been volatile in recent weeks but said the economy nevertheless seems likely to continue to expand at a moderate pace.

The Fed said that core inflation has "improved modestly in recent months" but "a sustained moderation in inflation pressures has yet to be convincingly demonstrated."

The bank said its "predominant policy concern remains the risk that inflation will fail to moderate as expected."

The news was not what Wall Street was looking for at first and stocks initially fell sharply after the bank's decision. But they then rallied to climb out the hole, ending the day up moderately.

The Fed also reported today that consumers boosted their borrowing in June, in apparent response to the slumping housing market and growing troubles in mortgage markets.

When home prices were rising sharply in value, consumers were taking out home equity loans and using other types of mortgage financing instead of relying so much on credit cards.

However, with rising defaults in the subprime mortgage market, lenders have tightened standards for mortgage loans, forcing consumers to move back to credit card borrowing.

The Fed reported that consumer credit rose at an annual rate of 6.5 percent in June, the second straight sizable gain.

Total consumer credit rose by $13.2 billion in June to a record $2.459 trillion. The increase was double what economists had been expecting.

Roller Coaster Ride

Wall Street had been eagerly awaiting the Fed's decision on interest rates after suffering through several jittery weeks. Stocks have been on a roller coaster ride recently, shooting up to new records one day and then plunging the next.

Interest rates have played a particularly important role. Banks and other lenders who gave mortgages to people with poor credit -- so-called subprime borrowers -- have seen those loans default at a higher than normal rate.

The mortgage problems are now extending to those with normal credit and lenders are clamping down, making it harder for people to borrow.

That tightening of credit is also expanding to businesses that want cash to grow or to acquire other companies. That concerns some on Wall Street who believe that deteriorating credit conditions may slow overall economic growth.

Things got worse when Bear Stearns, one of Wall Street's most-respected firms, had two of its hedge funds fall apart because of its subprime investments.

Then Friday, a Bear Stearns executive said during a conference call designed to quell investors fears that conditions in the credit market were the worst he has seen in his 22 years on Wall Street.

The comments, of course, had the opposite effect, sending the market into free fall only to see it once again rebound yesterday with the Dow Jones industrial average posting the largest one-day gain in five years.

That is where today's Federal Reserve decision comes in to play. Home buyers, credit card holders and the rest of the general public do not borrow at the rate set by the Fed, but their rates climb and fall with the central bank's decision.

Many investors had been urging the Fed and its relatively new chairman Ben Bernanke to cut interest rates to ease some of the these problems and to stimulate the economy.

But there is good reason for the Fed to keep rates steady. By holding steady, Bernanke is sending the message that the Fed is not going to bail out a bad financial situation created by irresponsible lenders.

Today's decision was the ninth straight time that the Fed has held rates steady.

This year of inactivity comes after a 17-month, stair-step run-up in rates from the historic lows seen after the 9/11 attacks. Back then, the Fed lowered rates to keep people and businesses buying after the emotional and economic trauma of the attacks.

The increase in rates was meant to bring things back to neutral, and then when prices started going up, thanks to a series of spikes in energy prices, to tamp down the threat of inflation.

And while the Fed did not change the rate, investors -- as always -- read a lot into the carefully worded statement the central bank released.

The Associated Press contributed to this report.