Fed stands firm, holds rates in face of market turmoil

7 hours ago Sept 17, 2008

WASHINGTON (AFP) - The Federal Reserve stared down pressure from markets and held its base lending rate at 2.0 percent Tuesday, suggesting the economy can muddle through the current turmoil without an immediate rate cut.

The unanimous decision by the Federal Open Market Committee headed by chairman Ben Bernanke defied expectations of traders in the futures market of a quarter-point reduction in the federal funds rate.

The FOMC cited "strains" in financial markets but said that the world’s biggest economy is likely to return to modest growth with the current low rates and other measures to increase liquidity.

The move came as a major surprise to traders, since the futures market had been pricing in a 92 percent chance of a quarter-point cut in the rate hours earlier in view of the rout in markets due to the collapse of Lehman Brothers and possible death spiral at American International Group.

Some analysts were perplexed by the decision.

"To read their statement, you would never know the sky has fallen in on Wall Street," said Ian Shepherdson, chief US economist at High Frequency Economics.

"In our view this statement is either very brave or very reckless. Not to acknowledge the catastrophes of the past few days runs the very serious risk that the Fed will be seen as Nero, fiddling while Wall Street burns."

Scott Brown, chief economist at Raymond James & Associates, said the decision signified "a lot of uncertainty" about the economic outlook and "allows the Fed to buy some time.

"Fed policy has an effect on the economy with a lag and the rate cuts earlier this year should be having an effect later this year," Brown said.

"There is always some second guessing. People will say ’What does the Fed know that the rest of us don’t?’ Now people are saying that maybe things aren’t that bad."

The FOMC statement noted that "strains in financial markets have increased significantly and labor markets have weakened further" since the last meeting in August but added that "the downside risks to growth and the upside risks to inflation are both of significant concern."

But it added that "over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth."

The central bank earlier Tuesday injected 70 billion dollars of liquidity through repurchase agreements, a move coming on the heels of similar actions by other central banks and another 70-billion-dollar move Monday amid turmoil following the bankruptcy of Wall Street giant Lehman Brothers.

John Ryding, economist with RDQ Economics, said the Fed nonetheless blundered in allowing market expectations to run so high in favor of a rate cut.

"In one way, I’m happy that the Fed did not cut rates," Ryding said while adding that the Fed’s "communication skills have ben far from perfect."

Ryding said the Fed was trying to demonstrate that the economy can get by with the current rate policy and that it will fight the credit crisis with alternative means of getting liquidity to institutions that need it.

Joel Naroff of Naroff Economic Advisors said the Fed decision appeared "reasonable" under the circumstances.

"The problem is not the level of rates but liquidity and the willingness to lend," Naroff said. "If the Fed had cut the funds rate, it would have lowered costs to financial institutions but not caused them to lend a whole lot more."

Sherry Cooper, chief economist at BMO Capital Markets said the Fed "has made the correct decision."

"The funds rate target at 2.0 percent is already very low and the FOMC is mindful of the hindsight criticism of the (Alan) Greenspan Fed in taking the rate down to 1.0 percent, which doubtless contributed to the housing bubble," she added.

"The central bank continues to add liquidity through open market operations; it doesn’t need a rate cut to do that."