Fed Keeps Rate at 5.25%

Fed Keeps Rate at 5.25%; Inflation Is Main Concern (Update6)
By Scott Lanman

Aug. 7 (Bloomberg) -- The Federal Reserve, keeping interest rates unchanged, said inflation is still the biggest danger to the economy and that the six-year economic expansion won't be undone by ``tighter'' credit conditions.

``Although the downside risks to growth have increased somewhat, the committee's predominant policy concern remains the risk that inflation will fail to moderate as expected,'' the Federal Open Market Committee said today after meeting in Washington, where it left the benchmark rate at 5.25 percent.

Some investors read the remarks to mean that Chairman Ben S. Bernanke won't rush to cut rates in response to a rout in the subprime mortgage market that's prompted lenders to restrict borrowers' access to credit with higher rates and fewer downpayment concessions. The world's largest economy will survive the tumult, the central bank added.

``Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing,'' the Fed said. ``Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.''

Traders pared bets on the chance the Fed will lower rates in the next few months, according to futures prices on the Chicago Board of Trade. The Dow Jones Industrial Average fell in the minutes after the decision, before rebounding. The Dow rose 35.52 points to 13,504.30 and the dollar strengthened against the euro. Treasury notes declined, sending yields on benchmark 10-year notes to 4.78 percent, from 4.74 percent late yesterday.

`Sticking to Guns'
``They are sticking to their guns,'' said David Kelly, an economic adviser at Putnam Investments LLC in Boston, which manages $193 billion in assets. ``They think the economy is fundamentally healthy and it will get through the credit-market issue. They don't want to do anything to panic.''

Several economists predicted the Fed would say risks were balanced between prices and slacker growth, foreshadowing a possible rate reduction.

``A sustained moderation in inflation pressures has yet to be convincingly demonstrated,'' the FOMC said, repeating a sentence from the last statement on June 28.

The mention of inflation as the ``predominant'' concern has appeared in each Fed statement since March and meeting minutes starting with last December's session.

The Fed statement comes less than three weeks after Bernanke delivered semiannual testimony to Congress, an event that usually sets the tone of central bank discussions for several months. He told lawmakers on July 18 and 19 that U.S. economic growth would pick up ``a bit'' and inflation recede.

Shift in Sentiment
Investor sentiment has shifted since benchmark stock indexes reached records in mid-July. The Standard & Poor's 500 Index dropped 5.7 percent from its all-time high on July 16 through yesterday.

The culprit: subprime mortgages that customers have been unable to repay, making securities linked to the loans less attractive. At Bear Stearns Cos., where two hedge funds failed in June, the firm's chief financial officer said Aug. 3 that the fixed-income market is in the worst shape in 22 years.

At least 70 mortgage firms have halted operations, gone bankrupt or sought buyers since the start of 2006. In addition, lenders such as Wells Fargo & Co. and Wachovia Corp. are raising rates and imposing stricter standards on some of their most creditworthy borrowers.
The Fed may be reluctant to reduce its benchmark interest rate, though, unless officials see inflation as under control.

Productivity
Slower productivity growth may boost inflation because it means companies have less cushion to absorb wage increases without raising prices. A government report today showed productivity rose at an annual rate of 1.8 percent in the second quarter, less than the 2 percent gain expected, based on the median forecast in a Bloomberg News survey.

Price increases have slowed for four straight months under the Fed's preferred gauge, which excludes food and energy costs. The core personal consumption expenditures price index rose 1.9 percent in June after a revised 2 percent gain in May, the Commerce Department said July 31.

The government also said on July 27 that the U.S. economy expanded at a 3.4 percent annual pace in the second quarter, the fastest in more than a year, after a revised gain of 0.6 percent in the three months ending March.

Economists and Fed officials anticipate a slacker expansion in the second half. For the year, Fed governors and presidents expect growth, on average, of about 2.25 percent to 2.5 percent, Bernanke told Congress last month. The projections are about a quarter-point below the previous round in February, mainly because of the weakness in homebuilding.

Consumer spending, which Bernanke said last month was ``likely to continue growing at a moderate pace, aided by a strong labor market,'' is showing signs of slowing. Auto sales last month were at their lowest July level in nine years. In addition, job growth slowed and the unemployment rate inched up to 4.6 percent, tying the highest rate since last August.