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Eyes on the Fed Full coverage

Fed holds steady, Lacker dissents again

Bernanke and Co. keep short-term target at 5.25% for fourth straight meeting as calls mount on Wall Street for cut.

By Paul R. La Monica, CNNMoney.com editor at large

NEW YORK (CNNMoney.com) -- The Federal Reserve Tuesday held interest rates steady for the fourth straight meeting - a widely expected move that comes as investors speculate about when the nation's central bank will begin to cut rates.

But the Fed also noted there had been a "substantial" cooling in the housing market, a possible sign the Fed may be concerned about the state of the economy. Stocks recovered some of their losses after the Fed's announcement while bonds moved higher.

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Fed policy-makers decided to keep their target for the federal funds rate, an overnight bank lending rate that influences rates on many consumer and business loans, at 5.25 percent.

The Fed had raised rates seventeen consecutive times in a bid to keep inflation in check but paused in August and has been on hold since. Many economists say the central bank may start cutting rates next year since economic growth has slowed, partly due to weakness in the housing market.

This tension has investors closely watching the Fed's pronouncements for clues about the Fed's next move on rates. Some have criticized the central bank for moving too slowly in the past to cut rates after a string of rate increases.

But the Fed indicated in its statement Tuesday that it is still worried about inflation - echoing recent comments by Fed Chairman Ben Bernanke and other officials about the central bank's desire to make sure prices for goods and services remain under control.

The Fed used the same language to describe inflation as it did when it last met in October, noting that "readings on core inflation have been elevated" but that "inflation pressures seem likely to moderate over time" due to lower energy prices and the effect of the Fed's previous rate hikes.

In addition, Fed member Jeffrey Lacker, who is the president of the regional Fed bank in Richmond, Va., voted again for a rate increase of a quarter of a percentage point.

That marks the fourth straight time that Lacker voted for a rate hike and in the minutes of prior meetings, Lacker has expressed concern about inflation as his main reason for dissenting. The other ten members of the Fed's policy committee voted to keep rates steady.

The Fed also noted some recent signs of softness in the economy. In its statement, the Fed said that "recent indicators have been mixed" but that "the economy seems likely to expand at a moderate pace on balance over coming quarters."

And the Fed made a subtle change to its assessment of the real estate market. It said there was a "substantial cooling" in the housing market. When the Fed met in October, it did not use the word substantial to describe the slowdown.

Economists said it's premature to expect a rate cut in the near future.

"There really was nothing much new here. The Fed still expects the economy to bounce back although there was a little more attention to the softening of the housing market," said David Resler, chief economist with Nomura Securities International.

Resler added that the Fed will need more evidence that the real estate slowdown is affecting consumer spending and the manufacturing sector before it would consider lowering rates. With that in mind, he said it's highly unlikely the Fed would cut rates at its next meeting in late January.

David Wyss, chief economist with Standard & Poor's, agreed.

"They are a little more concerned about economic growth and they didn't change the inflation paragraph. But don't hold your breath for a rate cut," he said.

Wyss said the Fed needs to see a pickup in the unemployment rate before it would be more worried about slower economic growth than inflation. Wages make up the biggest component of corporate expenses and therefore have a big impact on how much businesses charge for goods and services.

If the job market remains healthy, the Fed will continue to be concerned about inflation, Wyss said. He thinks that if the unemployment rate moves closer to 5 percent then the Fed would be more inclined to cut rates. The unemployment rate in November was 4.5 percent.

Wyss added he expects the unemployment rate to keep rising, however, and that by mid-2007, the Fed may be ready to lower rates.

Traders seem to share this assessment. According to fed funds futures traded on the Chicago Board of Trade, investors are betting there's just a small chance of a rate cut when the Fed next meets in late January. But they're betting a rate cut's much more likely by the time the Fed meets in June.

Tom Higgins, chief economist with Payden & Rygel, a Los Angeles-based money management firm, said the Fed is unlikely to cut rates until it gives the market a signal first that it is no longer concerned with inflation.

Specifically, he said the Fed would probably want to change the part of its statement where it says "the Committee judges that some inflation risks remain" to something that signals the Fed sees an equal risk of inflation and an economic slowdown.

Higgins said that if retail sales during the holidays are weak and if inflation is relatively tame, that could prompt the Fed to change its statement as soon as January. And if that's the case, Higgins said the Fed could cut rates twice by the middle of next year. He said the weakness in the housing market is just the beginning of a broader slowdown.

"Housing is a canary in a coal mine. It's telling you that interest rates are starting to take a bite out of growth and that with a delay, the overall economy is going to slow. We should see more evidence of that," he said.

Investors clearly are hoping for rate cuts and seemed slightly disappointed that the Fed's statement did not provide clear evidence that lower rates were coming soon.

Stocks pared their losses right after the announcement but quickly moved lower again and closed down for the day. Investors in stocks like rate cuts because they tend to spur the economy and boost corporate profits, thus lifting stock prices.

Bonds rallied, pushing the yield on the benchmark 10-year Treasury down to 4.48 percent from 4.52 percent late Monday. Bond prices and yields move in opposite directions.

Some bond investors seem to be betting that the economy is weakening and that the Fed should be lowering rates to stave off the risk of a significant slowdown. The fed funds rate is currently higher than the 10-year bond rate and other long-term rates. This phenomenon is known as an inverted yield curve and has typically been a predictor of a recession.

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