Fed Keeps Rate at 2% as Economic Growth Stagnates (Update4)

By Craig Torres


Aug. 5 (Bloomberg) -- The Federal Reserve kept its benchmark interest rate at 2 percent and signaled that weak employment and financial instability will delay any increase in borrowing costs.

``Labor markets have softened further,'' the Federal Open Market Committee said in a statement today in Washington. ``Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth.''

Stocks extended gains on speculation that policy makers will leave the rate unchanged in coming months. Officials said they still expect inflation to slow, while acknowledging that the outlook for prices is ``highly uncertain.''

``This says the Fed is on the hold for the rest of the year,'' said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina, and a former chief economist at the Senate Banking Committee. ``The next move may be up, but it won't occur for a while.''

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

``Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the committee,'' the statement said.

The Standard & Poor's 500 Index gained 35.87 points, or 2.9 percent, to 1,284.88. Stocks were also pushed higher by a retreat in crude oil prices. The yield on the 10-year Treasury note rose 6 basis points to 4.02 percent as investors concluded that a crackdown on inflation isn't imminent.

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.

``They are sending the right signals,'' Martin Feldstein, an economics professor at Harvard University, said in a Bloomberg Television interview. While policy makers are concerned about inflation, ``they are also very worried about the weakness in the economy.''

Central-bank Trifecta

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.

``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.''

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.

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.

`Dovish Side'

``The change was subtle and marginal, but the shift was more to the dovish side,'' said Michael Darda, chief economist at MKM Partners LP in Greenwich, Connecticut. ``The most visible change was removing the part of the June statement that downside risks had diminished somewhat. That is an acknowledgement of what has been going on in the credit markets. There was a subtle downgrade in growth prospects.''

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.

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.

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.

`Uncomfortable'

``Policy is firmly on hold,'' said Paul Kasriel, chief economist at Northern Trust Corp. in Chicago, and a former Fed economist. ``The Fed has to feel uncomfortable with the Fed funds rate below where headline inflation is. That makes them nervous and disinclined to cut interest rates.''

``At the same time, the Fed is looking at very restrictive credit conditions and thinking consumer spending in the last quarter was driven by rebates,'' Kasriel said.

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.