inflation has risen to its highest level in 17 years

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Federal Reserve leaves key interest rate at 2%
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STANDING PAT





HOW THE FED WORKS

The Federal Open Market Committee: Who votes on setting interest rates?






Yahoo! Buzz Digg Newsvine Reddit FacebookWhat's this?By Barbara Hagenbaugh, USA TODAY
WASHINGTON — Federal Reserve policymakers Tuesday left interest rates unchanged and stressed they are concerned about both the struggling economy and high inflation, suggesting rates are likely to remain where they are for some time.
Stocks jumped, in part because there was nothing in the Fed statement to scare or surprise investors. The Dow Jones industrial average, which rose early after a fall in oil prices, gained 332 points, or 2.9%. Its close at 11,616 recoups its loss of the last 10 trading days. Data showing the services sector shrank less than anticipated also helped stocks.

In a 10-1 decision, Fed policymakers left their target for short-term interest rates, which influence the cost of borrowing to buy everything from cars to condos to couches, at 2%. The Fed has kept the rate — the lowest since late 2004 — unchanged for more than three months.

In their post-meeting statement, Fed Chairman Ben Bernanke and his colleagues noted the job market had weakened, financial markets were "under considerable stress" and tight credit, the housing downturn and high energy costs were "likely to weigh on economic growth over the next few quarters."


WHAT THE FED SAID: Full text of the FOMC statement

At the same time, the Fed said that while inflation should "moderate," the outlook for prices was "highly uncertain" and inflation is a "significant concern."

Such dueling worries suggest the Fed does not plan to raise or lower rates in coming months.

John Derrick, director of research at U.S. Global Investors in San Antonio, says a rate increase is just as likely as a rate cut. "They really went right down the middle to straddle that fence as best they could," Derrick says. "They are basically in risk assessment mode."

Says Argus Research economist Richard Yamarone: "The only thing you can expect from the Fed for the next five months is open mouth policy: Talk up the dangers of inflation, but no action."

The Fed's decision comes as the economy struggles with rising unemployment, a continued housing slump, slowing consumer spending and stagnant manufacturing activity. At the same time, inflation has risen to its highest level in 17 years, led by higher food and energy costs.

There has been some good news this week on inflation. Oil prices on Tuesday fell $2.24 to $119.17, the lowest since May 2. The U.S. average price of a gallon of regular was $3.871, down a penny from Monday and 24 cents lower than the record hit July 17, according to motor club AAA.

But oil prices still are up 65% from a year ago, and prices for other items have also been rising. Such inflation concerns, along with tight credit, have kept borrowing rates, such as mortgages, elevated.

The Fed is in an interest-rate bind as the weak economy gives the Fed less latitude to raise interest rates to address inflationary pressures. The Fed typically cuts interest rates to boost the economy and raises them to halt inflation.

If the Fed in statements and speeches lets investors know they are on the inflation ball, that can still help, says Greg McBride, senior financial analyst at Bankrate.com.

"Although talking tough is all they can really do at this point, if it quells some of the inflation jitters in the marketplace, consumers could ultimately benefit through lower mortgage rates. And lower inflation would deliver some real returns to savers' pocketbooks," McBride says.

Mortgage rates have moved higher in recent months in response to inflation fears. The average rate on a 30-year fixed mortgage was 6.52% last week, according to Freddie Mac. That was down from the 6.63% average seen in the prior week, but higher than the 6.06% average in the week the Fed made its last interest rate cut in late April.

The Fed's decision to leave rates unchanged means the average rate for certificates of deposit won't change much. Last week, the average rate for a 1-year CD was a meager 2.29%, while the average rate for a 5-year CD was 3.46%, according to Bankrate.com.

However, savers who are willing to shop around can find much better deals from banks that are trying to increase deposits. Wachovia Bank, for example, is offering 4.25% on a 1-year CD with a $5,000 minimum deposit.

Rates for home equity lines of credit, which averaged 5.54% last week, probably won't increase, which is good news for borrowers who have access to a home equity line. However, the collapse of the housing market has made it more difficult for homeowners to qualify for these loans. Some lenders have stopped offering home equity lines, and others have frozen home equity lines for their existing customers.

Some more downbeat economic news came Tuesday. The Institute for Supply Management said activity in the service sector contracted for the second consecutive month in July, led by a significant drop in orders.

But conditions were a little brighter than in the previous month. ISM said its non-manufacturing index was 49.5 in July, up from 48.2 in June. Numbers below 50 suggest contraction; those above suggest expansion.

And although employers continued to cut workers, they did so at a slower pace in July than in June, the group said.

Still, the news wasn't good for the services sector, which accounts for the vast majority of U.S. economic activity, says Anthony Nieves, chairman of the ISM services panel and senior vice president for supply management at Hilton Hotels.

The index is "not really giving us any positive indication at this point," he says.

In other economic news, the International Council of Shopping Centers Tuesday said sales at retail chain stores last week were unchanged from the prior week.

The Fed's Board of Governors in Washington moved a step closer to becoming fully staffed Tuesday. Elizabeth Duke, formerly chief operating officer at TowneBank, a Virginia-based community bank, was sworn into office Tuesday morning.

All seven seats at the Fed Board have not been filled since June 2006 as members have resigned and nominees have not been voted on by the Senate.

There are now two open slots at the Fed. One of those is being filled by Gov. Randall Kroszner, who is awaiting confirmation to a new term after his seat expired earlier this year. Another slot will open up at the end of August when Gov. Frederic Mishkin is scheduled to leave the Fed.

Contributing: Sandra Block