Fed Keeps Rate at 2%

Fed Keeps Rate at 2% as Inflation Accelerates, Growth Stagnates

2008-08-05 18:13:36.80 (New York)

By Craig Torres

Aug. 5 (Bloomberg) -- The Federal Reserve kept its benchmark interest rate at 2 percent for the second consecutive meeting as inflation accelerates and the economic slowdown shows signs of deepening.

``Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the committee,'' the Federal Open Market Committee said in a statement today in Washington.

Chairman Ben S. Bernanke is constrained by threats to both sides of his mandate to achieve stable prices and full employment. A rate cut risks pushing inflation higher still; an increase would further tighten credit, undermine troubled banks and starve the faltering economy of investment and spending.

``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.''

Dallas Fed President Richard Fisher dissented for a fifth time this year, preferring an increase.

``Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities,'' the Fed said. ``The committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.''

Bleaker Scenario

America's economic outlook has deteriorated since policy makers last met on June 25, when they paused after the most aggressive series of rate reductions in two decades.

Gross domestic product shrank in the fourth quarter, and grew at just an average 1.4 percent annual rate in the first six months of this year, aided by some $78 billion in tax rebates mailed between late April and June. The consumer price index rose 5 percent for the year ending June, and the unemployment rate climbed to 5.7 percent.

``As a policy maker, it doesn't get any worse than this,''

Fed Governor Frederic Mishkin said after a speech in Washington on July 28. He will leave the central bank at the end of the month.

The Fed is the first of three major central banks to set interest rates this week. The European Central Bank and Bank of England, also beset by faltering expansions and faster inflation, are forecast by economists to stand pat.

Housing and Credit

Fed policy makers have cut the benchmark rate by 3.25 percentage points since the global credit market began unraveling a year ago. The worst housing slump in a generation sparked a surge in defaults. That led to the collapse of the market for assets backed by subprime mortgages and more than $450 billion in asset writedowns and credit losses by the world's biggest banks and securities firms.

``We are not necessarily out of the woods with regard to financial market turmoil,'' Brian Sack, vice president at Macroeconomic Advisers LLC in Washington, said before the announcement. ``Any significant disruption to financial markets could lead to a significant tightening of financial conditions and weaken the outlook abruptly.''

Residential investment has subtracted from GDP for 10 consecutive quarters, detracting 0.6 percentage point from the second quarter's 1.9 percent annualized growth rate. The S&P/Case-Shiller index of home prices in 20 metropolitan areas fell 15.8 percent in May.

The deterioration in housing produced a new bout of financial instability for policy makers in July. Shares of Fannie Mae, the largest U.S. mortgage-finance company, and Freddie Mac, the second largest, plunged in panicky trading, impairing their ability to raise new capital by selling stock.

At the request of the Treasury, the Fed's Board of Governors agreed July 13 to loan to the companies if the Treasury's own financial backstop was insufficient.

Wall Street Loans

Persistent stress and risk aversion in global financial markets also caused the Fed to extend some of its lending to investment banks until January.

``If the financial system unwinds, we could have a protracted period of slow growth,'' Mark Gertler, a New York University economist and research co-author with Bernanke, said in a Bloomberg Television interview before the announcement.

``That is what the Fed is trying to avoid.''

President George W. Bush signed into law last week a rescue package for Fannie Mae and Freddie Mac that permits the U.S.

Treasury to support the companies in an emergency with purchases of unspecified amounts of their securities. The Treasury's authority expires at the end of 2009.

`Limping Along'

Crude oil prices are up 68 percent in the last 12 months, and higher energy costs are cutting profits across industries, and eroding consumer purchasing power.

General Motors Corp. reported a second-quarter loss of

$15.5 billion Aug. 1, the third biggest in its 100-year history, due to declining sales. Kimberly-Clark Corp. said July 24 that second-quarter profit fell 9.8 percent because of higher costs for pulp and oil to make products such as paper towels and kleenex tissues.

``Energy price increases are forcing major adjustments in many industries,'' former St. Louis Fed president William Poole said in a Bloomberg Television interview on Aug. 1. ``The economy is limping along right now around zero'' growth.

The rise in consumer spending for the year ending June was the smallest since the 12 months ending December 1991.

The personal consumption expenditures price index, a separate inflation measure tied to consumer purchases closely watched by Fed officials, rose 2.3 percent minus food and fuel for the 12 months ending June. Fed officials in June forecast the core inflation measure would rise 1.8 to 2 percent in 2010, an indication of their preference range.

--Editor: Daniel Moss, Mark Rohner

To contact the reporter on this story:

Craig Torres in Washington at +202-654-1220 or ctorres3@bloomberg.net

To contact the editor responsible for this story:

Chris Anstey at +1-202-624-1972 or canstey@bloomberg.net