Fed Holds Rates Steady, Despite Turbulence

WASHINGTON (Reuters) – The Federal Reserve held U.S. interest rate steady on Tuesday, opting to soothe rattled financial markets with central bank lending and saying it was worried both about economic weakness and price pressures.

The U.S. central bank’s unanimous decision leaves the interbank overnight federal funds rate at 2 percent, where it has been since April. It said “downside risks to growth and the upside risks to inflation are both of significant concern,” surprising many in financial markets who had expected the Fed to signal greater worries on growth.

Investors had begun to speculate this week that the central bank would lower rates in the wake of the bankruptcy of 158-year-old Lehman Brothers Holdings Inc, the sale of investment bank Merrill Lynch to Bank of America, and a scramble for cash by insurer American International Group Inc.

U.S. stocks initially dropped in a sign of disappointment, but quickly turned higher. The dollar gained on the euro and prices for U.S. government bonds held steady.

“Strains in financial markets have increased significantly and labor markets have weakened further,” the Fed said in a statement announcing its decision. “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,” it added.

However, the central bank said already low benchmark interest rates and steps it has taken to ease funding strains in credit markets should help to promote growth over time.

While many analysts were surprised the Fed opted not to lower benchmark borrowing costs, some said policy-makers probably decided that doing so would have little effect.

“You could cut Fed funds rate from 2 percent to 1.5 percent, it won’t cause any more lending. The banking system has no capital base to lend,” said George Feiger, chief executive at Contango Capital Advisors in Berkeley, California.

“It may be psychologically nice if they want to play day games with the stock market, but why will they want to do that?,” he asked.

RATTLED MARKETS

Swift-moving financial developments have rattled global markets and threaten to exacerbate a credit crunch that has already helped push the U.S. economy toward recession.

On Sunday, the Fed said it would accept a wider range of collateral, including equities, from investment banks seeking central bank loans in an effort to help keep markets functioning.

As Fed officials met, talks aimed at helping AIG through its cash crunch entered a second day at the New York Federal Reserve Bank. Officials from the Fed, U.S. Treasury and New York state and financial firms were involved.

On Monday, the holding company for Lehman Brothers filed for bankruptcy and Bank of America announced it was buying Merrill Lynch. Rival investment bank Bear Stearns narrowly avoided default in March through a cut-rate sale to JPMorgan Chase that the Fed helped facilitate with a $29 billion guarantee on some of Bear’s troubled assets.

The sharply shifting financial landscape had pulled the rug out from under markets on Monday, with the Standard & Poor’s 500 index posting its biggest one-day percentage loss since reopening after the September 11 attacks in 2001.

Other markets were also sent reeling and the Fed and other central banks around the globe pumped cash into interbank markets to try to keep them from seizing up.

The Fed’s emergency weekend action came just a week after the government announced a federal takeover of mortgage finance giants Fannie Mae and Freddie Mac and a pledge to inject up to $200 billion in the companies to help keep mortgage markets functioning.

A weakening economy hit hard by a housing bust and credit crisis had led the Fed to lower rates by 3.25 percentage points in seven steps from mid-September 2007 to the end of April.

But surging energy and commodity prices pushed officials to the sidelines as worries grew on inflation.

A government economic stimulus package and demand for U.S. products abroad helped the economy grow at a relatively robust 3.3 percent annual pace in the second quarter. However, growth is expected to flag in the second half of the year as consumer spending dries up and demand for U.S. exports wanes.

U.S. employers have shed jobs for eight months in a row, and the unemployment rate hit a five-year high of 6.1 percent in August. Although the dismal jobs picture signals headwinds for the economy, it suggests price pressures could ease.

In a sign that the recent bout of energy-led inflation pressures may have peaked, the government said on Tuesday that the consumer price index fell 0.1 percent in August, the first decline in almost two years.

As the credit crisis has unfolded, the Fed has tried to distinguish between malfunctioning credit markets and weakening economic growth in charting its policy course. It has taken a range of steps to make credit more broadly available.

By Mark Felsenthal

(Additional reporting by David Lawder; Editing by Tim Ahmann)