Fed holds rates steady again

NEW YORK (CNNMoney.com) -- The Federal Reserve held a key short-term interest rate steady Wednesday but seemed to acknowledge that problems in the housing market could spill over into the broader economy - news that was widely applauded on Wall Street.

Stocks and bonds rallied after the Fed's statement appeared to indicate that the central bank was a bit more concerned about slowing growth than it had been in prior months. That could mean the Fed is not likely to raise rates in the near term and might even start cutting them if need be later this year.

Investors were also relieved the Fed did not specifically mention problems in the subprime mortgage market, taking that as a sign that rising defaults among borrowers with poor credit histories may not be that big of an issue. The Fed did say inflation was still the main risk going forward, however.

"The Fed is not lowering their guard on inflation and they've been telling the market that for some time," said Oscar Gonzalez, an economist with John Hancock Financial Services in Boston.

The Fed kept its target for the federal funds rate, an overnight bank lending rate that helps determine rates on credit card, home equity and other loans, at 5.25 percent. It was the sixth consecutive meeting where the Fed did not change rates after raising rates seventeen straight times between June 2004 and June 2006 in order to fight inflation.

But the Fed did indicate in its statement that recent economic indicators "have been mixed" and that the "adjustment in the housing sector is ongoing." The Fed added that "future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth."

This was the first time in several meetings that the Fed failed to say that "additional firming" would be needed to address the risk of inflation, language meaning the Fed was still leaning more toward raising rates rather than lowering them.

Stocks surged after the announcement, with the Dow ending up almost 160 points, or 1.3 percent. The broader S&P 500 and Nasdaq shot up 1.7 percent and 2 percent respectively.

Bond prices also rallied as investors bet on lower rates ahead, pushing the yield on the benchmark 10-year Treasury note down to 4.54 percent. Bond prices and yields move in opposite directions.

But one market observer noted investors may be overreacting, and that the changes in the Fed's statement may not mean the central bank is more likely to cut rates.

"The statement might reflect more a desire to clear up the language than it is a change in attitude or in stance. The balance of risk is still skewed more towards inflation rather than a weakness in growth," said Chris Probyn, chief economist with State Street Global Advisors in Boston.

Gonzalez at John Hancock agreed. He said the Fed still is clearly worried about inflation, especially since reports about consumer and wholesale prices for February showed a slightly higher-than-expected increase in prices.

"This is not to say they see inflation as a real problem but certainly they still feel uncomfortable with the fact that core inflation hasn't declined enough so they could say it's down for the count," he said.

Probyn added that the absence of the "additional firming" phrase is not that significant since the new sentence about policy adjustments was overly general.

"When will future policy adjustments not depend on the evolution of the outlook for both inflation and economic growth? That is a statement of the obvious and is in many ways redundant. I would not get too excited about this," Probyn said.

Economists and investors widely expected the Fed to leave rates alone but there has been a growing hope the central bank would cut rates later this year due to concerns about rising mortgage defaults, weakened consumer spending and other signs of an economic slowdown.

Fed Chairman Ben Bernanke and other current board members have stressed that the economy remains on solid ground. But former Fed chief Alan Greenspan has remarked in recent speeches that the subprime mortgage crisis could spill over into other areas of the economy and has also said that there is the possibility of a recession by year's end.

Another economist said that the Fed not making a big fuss about the subprime problems could be another reason the market jumped as much as it did.

"This is a relief rally since the Fed did not mention subprime," said Richard Yamarone, chief economist with Argus Research. "If the Fed didn't even mention it, clearly it can't be that big of an issue. The fear was that if the Fed mentioned it, it would be an even bigger concern than investors had imagined."

Nonetheless, Yamarone agreed with Probyn that the Fed is probably not going to cut rates anytime soon. He thinks the central bank is likely to leave rates at 5.25 percent for the remainder of the year.

This actually was the consensus view of many economists and investors before the subprime mortgage market started to unravel late last month.

But another economist noted that even though the Fed did not specifically use the term "subprime" in its statement, it clearly does recognize that weakness in the housing market still has the potential to derail economic growth.

Ken Kim, an economist with Stone & McCarthy Research Associates, an economic and fixed income research firm based in Princeton, N.J., pointed out that the Fed backtracked on what it said about housing at its last meeting in January.

In that month's statement, the Fed said "tentative signs of stabilization have appeared in the housing market." As such, Kim thinks the Fed does realize that housing woes could hurt the broader economy - and that the Fed will act accordingly.

"There were some significant word changes in the policy statement. The housing concerns led them to omit 'additional firming' this time around," Kim said. "The market is interpreting the statement as the Fed being closer to cutting rates sooner rather than later and I think the Fed will cut rates later this year."

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