NEW YORK (CNN/Money) - Federal Reserve policy-makers held a key short-term interest rate steady Tuesday, but said the risks to the U.S. economy were tilted toward weakness.
The nation's central bankers left their target for the federal funds rate, an overnight bank lending rate, at 1.25 percent, a 41-year low. But in the closely watched statement accompanying its decision, the Fed said recent economic indicators have been "disappointing."
Though policy-makers said the elements were in place to help the economy in the long run, in the short run they are more worried about the prospect of deflation -- an unstoppable drop in prices that hurts corporate profits and worsens the economy -- than inflation.
"The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level," the Fed's statement said. "The [policy-making] committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future."
Though the Fed's rate decision was expected, its statement did surprise many analysts, and U.S. stock prices briefly retreated a bit, though they held on to gains in afternoon trade. Treasury bond prices recovered from earlier losses. The dollar briefly extended its losses versus the euro.
Reasons for hope, reasons to worry
With the fed funds rate so close to zero, many economists think policy-makers want to delay making any more cuts until absolutely necessary, though Tuesday's statement hinted the Fed was willing to cut again if the economy's weakness lingers much longer.
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"By telling us that the risks are more heavily weighed towards weakness while simultaneously stating that they expect an economic recovery within the next several calendar quarters, they are revealing that they remain willing to act if they need to while also reassuring financial markets that there is no need for panic over the near term," said Anthony Chan, chief economist at Banc One Investment Advisors.
Though there have been recent signs of weakness in the economy -- especially in the labor market and in manufacturing, as the Fed noted Tuesday -- there have also been some signs of improvement, including a rebound in stock prices and consumer sentiment.
The Fed cut rates 11 times in 2001 in an effort to battle the recession that began in March of that year and likely ended before 2002. Economic growth went on a roller-coaster ride for much of 2002, and a dip in the fall inspired the Fed to make yet another cut in its target for the fed funds rate.
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Amid weak job market, more workers take on lower paying jobs to fill gaps.
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But Fed officials, including Chairman Alan Greenspan, have often said they think the economy's biggest problem during the latest downturn was uncertainty about the effects of a U.S.-led war with Iraq. After its policy meeting in March, the Fed avoided making a prediction about the economy's future, saying the fog of war made forecasting impossible.
With that war over, however, and with oil prices lower, interest rates low, a tax cut likely later this year, higher stock prices and a falling dollar, there would seem to be plenty of stimulus to push the economy to growth later this year.
Still, the Fed's statement was hardly a resounding expression of confidence:
"The committee perceives that over the next few quarters, the upside and downside risks to the attainment of sustainable growth are roughly equal," its statement said.
'The odds of a cut are 90 percent'
Some economists worry demand won't rebound enough to force businesses to ramp up production or expand their capacity significantly. Without such a burst of activity, there would be little need to hire new workers, meaning the labor-market pain of recent months could linger.
Payrolls are 2.1 million jobs leaner than they were in March 2001 outside of the farm sector, and employers cut about 525,000 jobs in the past three months alone. Economists worry continuing labor-market weakness could erode consumer confidence and keep a lid on consumer spending, which fuels more than two-thirds of the nation's economy.
And though the Institute for Supply Management's survey of non-manufacturing activity in April showed a rebound in the service sector -- the biggest employer in the economy -- the ISM's more closely watched index of activity in manufacturing showed another, unexpected decline.
Though manufacturing makes up only one-sixth of the total economy, its employees are some of the best-paid, and most of the jobs lost since March 2001 have been in this sector.
"The manufacturing side of the economy has been contracting for a couple of months in a row, and the rate of decline has accelerated. That's pretty scary," said Robert MacIntosh, chief economist at Eaton Vance Management in Boston. "The odds of a cut are 90 percent, and I'm not ruling out the chance there will be a cut between [policy] meetings."
Tax cut or rate cut?
MacIntosh said another cut could inspire another round of mortgage refinancing, which has helped put cash in consumers' pockets for several months. Other economists, however, wonder how much good another rate cut will do. They worry consumers have already borrowed too much and that something needs to be done to stimulate demand, rather than again increase money supply.
President Bush is pushing Congress to pass $550 billion in tax cuts, which he claims will stimulate job growth and demand. The Senate wants a tax cut of only about $350 billion, but further signs of economic weakness might help the president's cause, which has been flagging in recent weeks.
"The deflation concerns give ammunition to the president's tax cut," said Sung Won Sohn, chief economist at Wells Fargo & Co.
Still, many economists doubt a tax cut of any size will stimulate much demand in the short term, and many point out that the extra money in the president's plan goes towards a cut in dividend taxes, which would likely have even less of a short-term economic impact.
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