Fed holds rates steady, dials up inflation worry


Posted at Jun 26 2008 06:33 AM | Updated as of Jun 26 2008 02:33 PM


WASHINGTON - The Federal Reserve held interest rates steady on Wednesday and voiced greater concern about inflation, taking a small step down a road toward higher borrowing costs.

The decision by the US central bank, announced at the end of a two-day meeting, leaves the benchmark federal funds rate at 2 percent.

"Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased," the Fed said.

US stock prices rose and prices for US government bonds initially fell after the announcement. Bond prices, however, later reversed course as traders scaled back expectations for a rate hike at the Fed's next meeting in August.

"The Fed is going to need to start hiking interest rates at some point to start to deal with inflation," said Matt King, chief investment strategist with Bell Investment Advisors in Oakland, California. "That's a bigger risk than recession."

In its statement, the Fed said "overall economic activity continues to expand." After its last policy meeting on April 30, it described economy activity as "weak."

The Fed's policy-setting panel voted 9-1 in favor of the decision. Dallas Fed President Richard Fisher dissented, saying he preferred to raise rates.

It was the first time the Fed has held rates steady at a policy-setting session since embarking on a series of rate reductions in September to put a floor under an economy hit hard by a housing downturn and credit crisis.

Policy-makers at the central bank are at a difficult juncture. A deepening housing decline looks like it will be a drag on economic growth for months to come, even as higher oil and commodities prices threaten to ignite a broader inflation.

Senior Fed officials in recent weeks have said that risks of a serious recession had receded after a period of turmoil marked by surging mortgage delinquencies and the near-bankruptcy of investment bank Bear Stearns, and they have begun to turn their sights on the need to contain inflation.

While the Fed focuses on so-called core prices that strip out volatile food and energy costs as the best gauge of inflation trends, policy-makers have expressed concern that record-high oil prices could trigger a wider range of price increases.

Top Fed officials have said they would be particularly vigilant to ensure expectations of higher inflation do not build, warning that could set off a harmful upward spiral of rising prices and wages.

Oil prices have moderated after reaching a record just shy of $140 a barrel earlier this month. But other recent developments, such as an announcement from Dow Chemical Co, the largest US chemical maker, that it would raise prices by as much as 25 percent, have kept alive the specter of inflation.

At the same time, however, the economy has yet to show any clear signs of vigor.

The Commerce Department said on Wednesday that new single-family home sales fell 2.5 percent in May to bring them 40 percent below their year-ago level.

Reports released earlier in the week showed another leg down for house prices in April and a drop in consumer sentiment this month to a 16-year low.