Rates steady, statement soothes
The Fed holds a key short-term rate at 5.25 percent and Ben Bernanke & Co. calm market's fears about a credit crunch and inflation.
NEW YORK (CNNMoney.com) -- The Federal Reserve as expected left a key short-term interest rate unchanged Tuesday, but indicated in its closely scrutinized statement that it was concerned about growing credit problems in the economy.
Stocks initially fell sharply following the Fed's announcement, but quickly recovered as traders were calmed by the Fed's straightforward statement.
The central bank 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 ninth consecutive meeting that the Fed held rates steady after raising rates 17 straight times through June of last year.
Speculation has increased in recent weeks that the Fed might lower rates at least once by the end of the year due to concerns that woes in the subprime mortgage market are deepening. Problems in the debt markets could lead to a pronounced economic slowdown if banks tighten their credit standards for both home borrowers and corporations.
In its statement, the Fed noted that "financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing."
Fears of a credit crunch have caused some sizable drops in the stock market as investors appear to be betting that the merger boom, fueled in part by private equity firms borrowing money to finance deals, may be over.
But some economists and market watchers believe the Fed should not cut rates anytime soon since inflation is still a threat, particularly since oil prices are near record highs and the price of several other commodities such as wheat and milk have surged.
The Fed also said that "although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."
The Fed also indicated that it expects the economy "to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy."
John Norris, director of wealth management with Founders Financial, a Birmingham, Ala.-based investment firm focusing on high net-worth individuals, said investors may have at first been disappointed because the Fed did not clearly indicate that rate cuts were on the horizon.
"The market was looking for a hint about a future rate cut and what it got was a huge cold glass of water right in the face," Norris said.
But Norris added that the market may have realized after looking at the statement more closely that the Fed is doing its best to reassure investors and that it's not panicking about credit situations.
"When you look at the statement, it's hard to argue with it. It's straightforward and to the point. The Fed is not in a position where it should be having knee-jerk reactions like individual and institutional investors," he said.
Stocks, which were trading modestly higher before the announcement, went on a roller coaster ride afterwards. The Dow, S&P 500 and Nasdaq turned sharply lower immediately following the announcement but eventually bounced back in late-afternoon trading. The Dow finished the day up nearly 0.3 percent while the S&P and Nasdaq each gained 0.6 percent.
Bonds fell, pushing the yield on the benchmark U.S. 10-year up to about 4.77 percent. (Bond prices and yields move in opposite directions.)
One market expert said the Fed did a good job of showing Wall Street that it is monitoring both the credit problems and inflation closely and that is not overly concerned about either.
"The markets need some stability at this point. The statement will hopefully do what it was supposed to do, which is soothe the market," said Jonathan Smith, chief investment officer of fixed income for Haverford Trust, a money management firm with $6 billion in assets under management.
But another Fed watcher said the central bank is in a tough spot. Peter Schiff, president of Euro Pacific Capital, a brokerage that focuses mainly on overseas investments, said that if the Fed cuts rates, the already weak dollar would fall further and that could cause foreign investors to back out of U.S. Treasuries.
If that happened, long-term rates tied to these Treasuries would head higher. So a rate cut would be self-defeating.
"The Fed would love to cut interest rates but they can't. They are trying to keep the dollar afloat," Schiff said. "If Bernanke were to signal an imminent rate cut, the dollar would fall through the floor and long-term interest rates would be on the rise."
Norris agreed that the state of the dollar could keep the Fed on the sidelines for the foreseeable future.
"If the Fed slashed the overnight lending target, our dollar denominated assets would look really unattractive to Europe, China and Japan. They wouldn't buy as much and that would push up longer-term rates," he said. "The Fed is in a corner. It can't do much."
Still, other economists held out hope that a rate cut was in the cards.
Tom Higgins, chief economist with Payden & Rygel, a money management firm based in Los Angeles, said the Fed's statement was slightly more "dovish" than prior statements, meaning that the central bank may be more inclined to cut rates rather than raise them.
"We still think the Fed will eventually ease sometime in 2008," he said.
And in a note to clients, Clément Gignac, the chief economist and strategist with National Bank Financial in Montreal, pointed out that the Fed changed its assessment of the problems in the housing market to a "correction" as opposed to just an "adjustment."
Gignac wrote that "collateral damage from the U.S. housing recession continues to surface on a daily basis."
"In our opinion, growing evidence of spillover effects on credit markets and the economy will continue to mount in the coming months. Our long-held scenario that the Fed will cut rates before the year-end remains on track," Gignac wrote.