WASINGTON DC – The Federal Reserve, faced with a series of shocks to the U.S. financial system, left interest rates unchanged Tuesday, but said it’s watching developments carefully, meaning it the Fed could raise interest rates if inflation gets out of control.
The U.S. central bank, in a statement after its meeting, said “strains in financial markets have increased significantly and labor markets have weakened further,? The Wall Street Journal reported.
The central bank’s policy committee voted unanimously to leave the federal funds rate, at which banks lend to each other overnight, unchanged at 2 percent. It was the first fully unified vote since last September.
The decision gives the Fed more time to weigh the effects of the latest round of financial turmoil on the overall economy. Officials had hoped the broader fallout from the weekend would be limited, but they are closing watching markets – and other troubled firms – to gauge whether credit would tighten as a result.
The Fed said it would “act as needed” based on economic and financial developments. Officials were already expecting economic growth to weaken later this year. In their statement, they said tight credit conditions, the housing-sector contraction and slowing export growth “are likely to weigh on economic growth over the next few quarters.”
Still, the Fed said inflation and growth risks are both “of significant concern.” The statement said “inflation has been high” and the inflation outlook “remains highly uncertain.” But the committee still expects inflation to moderate later this year and next year.
The Fed went into this past weekend inclined to keep rates on hold for at least several months. While the U.S. economy expanded at a strong 3.3 percent pace in the second quarter, growth is expected to slow sharply in the coming months. At the same time, inflation worries are receding amid declines in the prices of crude oil and other commodities. After cutting rates sharply over the past year, from 5.25 percent last September, central-bank officials were increasingly comfortable with giving the financial system time to recover before raising rates.
Sometime next year, analysts had predicted, the Fed would finally make a move – a rate increase. But rate cuts came back on the table – with futures markets putting strong odds on a cut Tuesday – after a dramatic 10 days that threatened to topple the U.S. financial sector and exact deeper damage on the U.S. economy. In a rapid-fire series of events that began with the government takeover of mortgage giants Fannie Mae and Freddie Mac, officials have been forced to decide quickly which firms need to be saved to ensure the continued functioning of the financial system and which ones can fail without disastrous consequences for the markets and the broader economy.
Over the weekend, Fed and Treasury officials pushed for the sale of Lehman Brothers Holdings Inc., but the nation’s fourth-largest investment bank ultimately filed for bankruptcy protection. The government, which put up $29 billion to facilitate J.P. Morgan Chase’s purchase of Bear Stearns Cos. in March, this time rejected requests for taxpayer funds to help secure a sale.
At the same time, the struggling investment bank Merrill Lynch sold itself to Bank of America in a rushed weekend transaction. The series of moves, combined with fears surrounding insurance giant American International Group, rocked global financial markets. U.S. stocks fell sharply Monday, while some European and Asian markets declined even more.
The weekend before, top Fed officials helped coordinate the takeover of Fannie Mae and Freddie Mac. The government-chartered firms, which own or guarantee half of all U.S. mortgages, had faced the prospect of curbing lending for home loans at a time when the housing market continues to weaken. Now that they’re under direct government control, mortgage rates have eased.
The housing turmoil sparked a global financial crisis in August 2007 when banks, fearing exposure to other firms with bad mortgage debt, grew reluctant to lend. The resulting credit crisis forced the Fed and other central banks to respond with massive cash injections into financial markets and lending programs to ease strained conditions.
Policymakers initially sought to alleviate the credit-market stress by making it easier for commercial banks to borrow from the Fed’s discount window through lower rates. As market conditions worsened over the course of a year, the Fed engineered its broadest expansion of lending programs since the Great Depression to prevent short-term funding crises.
Six months ago, after the downfall of Bear Stearns, the central bank cited “unusual and exigent circumstances” to extend its lending to investment banks and began stationing staff inside the largest firms to monitor their conditions.
Throughout the crisis, Fed officials have sought to separate their lending function – keeping markets operating – from their monetary policy role of setting interest rates.
Policymakers started an aggressive effort to ease monetary policy beginning last September, when interest rates stood at 5.25 percent. Even before the economy showed signs of turning down, they cut rates to try to offset the threat posed by weakening financial conditions. A month later, many officials thought the financial markets might be on the road to recovery, making more rate cuts unnecessary.
But credit-market stress resurfaced and worsened, weighing on overall economic activity, and the Fed kept cutting rates. The U.S. economy contracted slightly late last year and by January employers were shedding jobs. Surging oil prices earlier in the year hit consumer spending, though a government stimulus package offset some of that pressure.
Once the Fed lowered its rate target to 2 percent in April, officials questioned whether further easing would help much. Key consumer rates, such as mortgages, stopped responding to Fed cuts because overall stress in credit markets. Some feared that easing policy would simply spur inflation problems in the long run.
This story appeared in the Wall Street Journal.
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