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Archive for Wednesday, August 9, 2006

Fed takes a break on rate increases

August 9, 2006

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— The longest unbroken stretch of interest rate increases in recent history is over - and the stakes couldn't be higher for Federal Reserve Chairman Ben Bernanke.

Six months into the job, Bernanke was confronted with a tough choice: hold rates steady and risk an inflation flare-up or boost them again and risk a sharper economic slowdown.

He and all but one of his colleagues on the Federal Open Market Committee chose Tuesday to pause its more than two-year rate-raising campaign. The effect on the economy may be a defining moment in Bernanke's tenure as Fed chairman.

Giving millions of borrowers at least a reprieve, the central bank held a key interest rate steady at 5.25 percent. The lone dissenter urged another quarter-point increase.

On Wall Street, stocks dropped on worries that the break was only temporary and that more rate increases might be in store. The Dow Jones industrials fell 45.79 points to close at 11,173.59.

The decision to take a breather comes as economic growth is slowing - a development that Fed policy-makers suggested eventually should lessen inflation risks posed by lofty energy prices.

To fend off inflation, the Fed had bumped up interest rates 17 times - in modest quarter-point increments - since June 2004.

The goal is to slow the economy enough to prevent inflation from taking off while not crimping activity so much that it brings on recession.

The end of a trend?

Since June 2004, when the rate was at a four-decade low of 1 percent, the policy-setting Federal Open Market Committee has lifted it 17 times by one-quarter of a percentage point at each of its meetings. The rate, which is 5.25 percent, indirectly affects many other interest rates.

"If inflation turns higher than people feel comfortable with, then Bernanke will be known as the chairman who let that happen, which will hurt the Fed's credibility in fighting inflation in the future," said Victor Li, economics professor at Villanova School of Business.

The decision to hold the federal funds rate steady means that commercial banks' prime lending rate - for certain credit cards, home equity lines of credit and other loans - stays at 8.25 percent.

That's welcome news for borrowers, who have watched interest rates march higher during the last two-plus years.

Before the Fed began to tighten credit in 2004, the prime rate stood at 4 percent, the lowest since 1958. The federal funds rate, meanwhile, was at 1 percent, a 46-year low. The Fed had sliced interest rates to rescue the economy from the 2001 recession, the Sept. 11 terror attacks and a wave of accounting scandals on Wall Street.

Tuesday's decision was difficult for the Fed. The lone dissenter was Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, Va., who said he would have preferred another quarter-point increase. It marked the first time since Bernanke took over that the Fed decision was not unanimous.

Bernanke and his colleagues observed that "economic growth has moderated from its quite strong pace earlier this year," partly reflecting a cooling in the once-hot housing market as well as the impact of the Fed's interest rates increases and high energy prices.

Although Fed policy-makers said some inflation risks remain, they predicted that "inflation pressures seem likely to moderate over time" given slowing economic activity and the toll of their previous interest rate increases - some of which are still working their way through the economy.

Some economists viewed that Fed language about inflation risks as striking a somewhat softer tone and predicted the Fed may stay on the sidelines for some time.

But some investors and other economists think another rate increase may be in store at the Fed's next meeting on Sept. 20 or later this year to thwart inflation.

The federal funds rate - the overnight rate that banks charge each other - influences other interest rates, including mortgage rates, and is the Fed's main tool for shaping economic activity.

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