Fed leaves rates unchanged

NEW YORK (CNNMoney.com) -- The Federal Reserve left its fed funds rate at 2% Tuesday despite increased hopes for a rate cut.

Wall Street wanted a cut in order to help ease the pain in the financial sector and restore investor confidence.

The Fed's policymakers acknowledged the deepening problems facing the nation's financial markets as well as weaker economic fundamentals in its statement.

"Strains in financial markets have increased significantly and labor markets have weakened further," said the statement, making reference to the jump in unemployment to a five-year high of 6.1% in August. It also warned that softer spending by consumers is expected to slow economic growth.

But the Fed added that it believes rates are already low enough to spur future economic growth and that despite recent declines in commodity prices, such as oil, the outlook for inflation remains uncertain.

The fed funds rate is the central bank's key tool to affect the economy. Lowering the rate pumps money into the economy by reducing the cost on a broad range of loans, including credit cards, home equity lines and many business loans.

Stocks initially fell on the announcement but bounced back and were higher in late afternoon trading even though expectations had grown in recent days that the Fed would respond to market turmoil by lowering rates.

According to futures contracts listed on the Chicago Board Trade, investors were betting Tuesday morning that a rate cut of at least a quarter-of-a-percentage point was almost certain.

Also lifting stocks were wire service reports that the Fed was considering loaning tens of billions to American International Group (AIG, Fortune 500), the nation's largest insurer and a key player in the financial markets. The Fed was said earlier to have reservations about lending to AIG but that may be changing.

AIG's scramble for cash this week is just the latest of the problems roiling the nation's financial markets.

In the past nine days, the Treasury Department took control of mortgage giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), investment bank Lehman Brothers (LEH, Fortune 500) filed for bankruptcy and Merrill Lynch (MER, Fortune 500) agreed to a buyout by Bank of America (BAC, Fortune 500).

In addition, shares of Washington Mutual (WM, Fortune 500), the nation's largest savings and loan, have plunged due to growing concerns that it too would have trouble raising necessary capital.

Keith Hembre, chief economist for First American Funds, said he thought a bailout of AIG made sense and that a potential rescue plan for the firm may have been one of the factors that stopped the Fed from cutting rates.

"If they were about to do an about face on AIG, that was probably a consideration on the rates," he said.

A Fed spokesman would not comment on the AIG report. But one possible indication of the Fed's involvement in any AIG discussions is that New York Federal Reserve President Timothy Geithner did not attend the meeting. Christine Cumming, first vice president of the New York Fed, voted in his place.

Geithner has been widely acknowledged as the Fed's main person involved in Wall Street efforts to save struggling financial firms.

In March, the Fed agreed to guarantee $29 billion in loans so that JPMorgan Chase would buy Bear Stearns. And Geithner led this weekend's last-minute efforts to save Lehman. Those talks between regulators and top banking officials were held at the offices of the New York Fed.

The New York Fed also pumped $50 billion into the nation's financial system Tuesday in an effort to help ease credit stresses.

Bernard Baumohl of The Economic Outlook Group in Princeton Junction, N.J., said that injection is a sign that the Fed recognizes it must deal with the problems facing Wall Street, even if it kept rates unchanged.

"The Fed is in effect saying, 'I'm not going to lower rates and subsidize the loan, but we're going to give you as much money as you need to conduct your operations," said Baumohl.

K. Daniel Libby, senior portfolio manager for Sands Brothers Asset Management, said he also believes the Fed made the right decision not to cut rates even though he remains worried about the outlook for AIG and Washington Mutual and other troubled financials.

"I am concerned about a number of banks and institutions being on the precipice of another downward spiral," he said. "But I don't know if [a quarter- point rate cut] would have helped us enough."

Libby said it's important for the Fed to not become too accommodative to the whims and demands of Wall Street.

What's more, the Fed may still wind up lowering rates later this year or early next year due to the weakness in the financial system, Hembre said. If the job market weakens further and oil prices continue to fall, that would reduce inflation fears and make it easier to justify a rate cut.

"We're likely to see inflation fall significantly and unemployment go higher, so that's a prescription for more Fed [cuts]," said Hembre.

Baumohl also noted that the Fed's decision Tuesday was unanimous -- the first time that's happened since early January.

Dallas Fed President Richard Fisher voted to raise rates at the last two meetings when they were left unchanged and voted against some of this year's rate cuts. Philadelphia Fed President Charles Plosser joined Fisher in some of his dissents during that period.

Baumohl thought the lack of a dissenting vote was key given the many fires that the Fed is trying to put out.

"This unanimity is important at this critical moment," he said.