Fed holds steady on interest rates

September 16, 2008 9:25:05 PM PDT
The Federal Reserve did not lower interest rates despite all the financial market upheavals in recent days, but that doesn't mean the central bank won't cut rates in coming weeks. Many economists believe Federal Reserve Chairman Ben Bernanke and his colleagues decided to save their remaining ammunition, given that their key lending rate is already at a low 2 percent, so that they will have room to make cuts later this year if markets remain turbulent.

In a statement explaining its decision not to move rates, the central bank did acknowledge the stomach-churning turmoil investors have seen since this weekend.

In a Wall Street restructuring the likes of which have not been seen since the Great Depression, Lehman Brothers, the nation's fourth largest investment bank, was forced to declare bankruptcy, brokerage giant Merrill Lynch was forced into a sale to Bank of America and the nation's largest insurance company, American International Group, was provided Tuesday night with an $85 billion loan from the Fed so that it could keep operating.

The Fed recognized this turmoil by declaring that "strains in financial markets have increased significantly."

But the central bank stopped short of cutting the funds rate further, which many investors on Wall Street had hoped to see as a confidence-building measure. Fed officials did not even signal that their next likely rate move would be to cut rates.

Instead, the Fed declared that the "downside risks to growth and the upside risks to inflation are both of significant concern."

Still, that phrase at least moved the Fed away from tilting toward an increase in interest rates, which is where it seemed to be headed with its next move. Now, economists said, the central bank has at least prepared the way for further rate cuts, with many analysts saying they are looking for two small quarter-point moves before the end of the year.

Analysts said they believe the economy will very likely not be able to avoid an outright recession given the latest financial shocks, which are expected to depress consumer spending even more. It was already weak in light of a rising unemployment rate, which in August hit a five-year high of 6.1 percent.

In addition, analysts said the Fed will be able to move to cut rates further because inflation, which had been seen as a threat when oil prices were surging, has begun to recede now that oil has fallen from an all-time high of $147 per barrel down to below $100 per barrel. The government reported Tuesday that a big drop in energy costs helped push consumer prices down by 0.1 percent in August, the first monthly decline in almost two years.

"The odds are rising that the Fed will cut rates before the year is out. The economy is going to weaken further, inflation will moderate measurably and the financial markets will remain unsettled," said Mark Zandi, chief economist at Moody's Economy.com.

Zandi said he is looking for the funds rate, which has not been changed since the Fed pushed it to 2 percent in April, will be at 1.5 percent by the end of this year.

Zandi said if financial markets remain unsettled, the first rate cut could occur before the Fed's next meeting on Oct. 28-29.

David Jones, chief economist at DMJ Advisors in Denver, said he is also looking for two quarter-point moves before the end of the year.

Jones said he was not surprised that the Fed did not cut rates this week, given that it was only a short time ago that Fed officials were signaling that their next move would be a rate increase. But he said the central bank should have revamped its statement to show that the balance of risks has now clearly shifted away from inflation to the threat of a recession.

Wall Street, which initially sagged on the Fed's announcement that rates would be unchanged, closed the day with a rally that was bolstered not by the Fed's rate decision but by reports that the central bank was about to provide a major cash-infusion for AIG. Fed officials later announced they would supply an $85 billion loan to rescue the huge insurer.

The Dow Jones industrial average rose by 141.51 points on Tuesday, one day after having fallen by 504 points as investors pushed down stocks by the largest amount since right after the Sept. 11, 2001 terrorist attacks.