Fed Leaves Interest Rate Unchanged

Sept. 16, 2008— -- The Federal Reserve unanimously decided this afternoon to leave a key interest rate unchanged despite renewed and deep fears about the health of the American financial system.

Since the central bankers last voted on interest rates in August, financial markets have deteriorated further and just yesterday the stock market had its worst single-day performance since the Sept. 11, 2001 terrorist attacks.

The Fed acknowledged all those concerns in its statement but still decided at this regularly scheduled meeting to keep the interest rate at 2 percent.

In its post-meeting statement, the Fed governors painted a bleak picture of the economy.

"Strains in financial markets have increased significantly and labor markets have weakened further," they said. "Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters."

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The committee also noted that inflation still remains high but expects it to moderate later this year and next year.

The stock market did not initially take the news well. The Dow Jones industrial average was up about 25 points right before the announcement but within 15 minutes was down 65 points. But just 15 minutes later, traders warmed up to the decision and the Dow was back in positive territory, up 25 points, and it ended the day up $141.51 points.

Economists were split before the meeting on whether the Fed would leave rates alone or make a cut. Most said that if a cut was to be made, it would have been a half a percentage point. Others said that no action today does not preclude the Fed from making an emergency cut before its next regularly scheduled rate meeting on Oct. 29.

The Federal Reserve has spent most of the past year aggressively cutting its key Fed Funds interest rate to stimulate an economy hammered by a collapsing housing market and the tightening of credit. Just a year ago, the rate stood at 5.25 percent.

Back after seven straight cuts, the Fed in June decided to leave rates at 2 percent. The main concern was quickly rising inflation, in part thanks to high oil prices. Others, however, said that despite the Fed's rate cuts, it wasn't doing enough to make new capital available – essentially no matter how cheap borrowing got banks were still hesitant to loan out cash.

After deciding again on Aug. 5 to leave rates steady, the Fed said, "Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain."

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Richard W. Fisher, president of the Federal Reserve Bank of Dallas was the lone vote in August against the committee's decision, instead favoring a rate increase. Since then, Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia, has also signaled a willingness to raise rates to combat inflation.

But all of that was thrown out the window in the past few days.

Just yesterday, 158-year-old brokerage firm Lehman Brothers filed for bankruptcy. And over the weekend Merrill Lynch, the world's largest brokerage, was sold to Bank of America is what many saw as a preventive move to stop it from collapsing.

That news came just a week after the government took over mortgage giants Fannie Mae and Freddie Mac.

Joseph A. LaVorgna, chief U.S. economist for Deutsche Bank, said in a research note that this was the first time in a while where the policy outcome of today's meeting was uncertain.

LaVorgna and his staff warned that a rate cut could actually "backfire."

"The ongoing market crisis is not about the price of credit, but rather the availability of credit," he wrote. "Right now, financial institutions are fearful of further bankruptcies and counterparty risk. A lower Fed Funds rate does not directly address this."

Instead, earlier today the Federal Reserve pumped $70 billion into the financial system -- $50 billion more than expected -- to get money flowing again into the economy. The goal of this action is to prompt banks to make loans for everything from business expansions to mortgages to student loans, all in an attempt to prevent further financial problems.

Ed McKelvey, an analyst with Goldman Sachs, said the Fed's decision was "a close call."

He said in a note that since the committee last met in August, "conditions in financial markets and in the labor market have deteriorated while inflation risks have abated."

In fact, just this morning, the government reported that consumer prices in August had their first monthly decline in nearly two years. Inflation had jumped 1.1 percent in June and 0.8 percent in July. But as gas and oil prices finally started to fall in August inflation fell 0.1 percent.

It was not a big drop by any measure, but some Fed watchers said it might give the Central Bank just enough ammunition to justify a further rate cut.

"The weekend's events … obviously underscore the intensity of the financial stresses weighing on the US economy," McKelvey said. Based on that, he added, markets had priced in "a significant probability" of a rate cut.

McKelvey doubted that would happen, saying that "until very recently, most Fed officials have been thinking about when would be the most appropriate time to start raising rates."

Additionally, he said, some members might feel that a rate cut would signal panic, and that's the last thing an already-busy Fed wants.