Fed holds rates steady again

NEW YORK (CNNMoney.com) -- The Federal Reserve left a key short-term interest rate unchanged Thursday and indicated it was still worried about inflation, a sign the central bank will leave rates alone for a while instead of cutting them despite concerns about a sluggish economy.

In its widely watched statement, the Fed eliminated its characterization of core inflation as being "elevated," saying that "readings on core inflation have improved modestly in recent months."

But the Fed added that "a sustained moderation in inflation pressures has yet to be convincingly demonstrated." The statement came out at the end of a two-day meeting for the Fed in Washington.

Investors seemed unsure how to react to the news. Stocks extended early gains right after the Fed's announcement but wound up pulling back, closing mixed for the day.

Treasury bonds fell, pushing the yield on the benchmark U.S. 10-year Treasury note up to 5.10 percent from about 5.08 percent late Wednesday. Bond prices and yields move in opposite directions.

The central bank, as widely anticipated, kept its target for the federal funds rate, an overnight bank lending rate that affects credit card, home equity and other loan rates, at 5.25 percent.

This was the eighth straight time that Fed Chairman Ben Bernanke and the rest of his policy-making committee took no action on rates after raising them 17 straight times, through June 2006, in order to fight inflation.

Although oil prices have crept back up toward $70 a barrel, several economists have said inflation should not be the biggest worry for the Fed.

"It's interesting that the Fed says inflation is still its top concern. What does inflation have to do? It is moderating as expected. I think the Fed is a little more hawkish than they need to be," said David Kelly, an economic advisor at Putnam Investments.

Still, others said the Fed cannot ignore the rise in oil prices and the recent spike in the prices for things like milk and corn. Even though so-called core inflation, which excludes volatile energy and food prices, may be tame, increased prices for oil and food are also key barometers of inflation.

"The Fed is trying to alert the markets that core inflation is back to where it likes it but headline inflation is at levels it doesn't like," said Richard Yamarone, director of economic research with Argus Research Corp. "The Fed realizes we don't reside in this no-food, no-gasoline world and that it appreciates how important increases in those prices are."

Brian Bethune, U.S. economist with Global Insight, an economic forecasting firm, added that no matter what the Fed really thinks about inflation, it should come as no surprise that the central bank still lists it as the top risk since it is the Fed's main job to monitor inflation.

"The whole statement was very much in line with market expectations and that's generally positive. The markets don't like to be surprised. I could have written this thing verbatim myself yesterday," Bethune quipped.

But Kelly and other economists argue that woes in the housing market should be a bigger concern, particularly since rising long-term bond yields have the potential to further dampen demand for mortgages and home buying.

"I think the economy is more vulnerable to a slowdown and the Fed may have mischaracterized the balance of risks here," Kelly said.

The Fed noted in its statement that "growth appears to have been moderate during the first half of this year, despite the ongoing adjustment in the housing sector." And it added the economy "seems likely to continue to expand at a moderate pace over coming quarters."

With that in mind, another economist said the Fed should pretty much be on cruise control for the foreseeable future. As long as the job market remains relatively strong, the Fed will keep focusing on inflation. But it won't want to cause further harm to the housing market by raising rates.

"The Fed won't cut rates as long as unemployment remains around 4.5 percent but there's no reason to tighten with the economy operating below potential. So there will be no change in policy in the near future," said Mark Zandi, chief economist with Moody's Economy.com, an economic research firm.

Wall Street seemed to agree. According to fed funds futures contracts on the Chicago Board of Trade, the likelihood that the Fed would cut rates by year's end decreased following the Fed announcement.

Global Insight's Bethune added that the Fed is in a good spot right now since inflation is easing and there does not appear to be any major risk of a recession.

"The Fed obviously has to be subdued but they are probably reasonably happy. The decision to keep rates steady for the past year has been vindicated," he said. "Trying to gently squeeze inflation out of the system is an extremely difficult thing to accomplish but it looks like the economy is heading for a soft landing."