Fed to hold rates steady and ride out storms

[September 15, 2008]  WASHINGTON (AP) -- Tighten your seat belt. Federal Reserve Chairman Ben Bernanke and his colleagues are doing just that as they prepare to ride out economic and financial storms by holding their most important interest rate steady this week and probably through the rest of this year.

Unemployment is rising, consumers are clamping down as paychecks shrink and the government snatched control of troubled mortgage giants Fannie Mae and Freddie Mac as it battles the worst financial and credit crises in decades.

The Fed is also working with the Treasury Department to help resolve Lehman Brothers Holdings Inc.'s search for a financial lifeline. Fed officials have been having conversations with relevant parties and getting updates, but a resolution is not expected to involve the use of government money.

"There is a witch's brew of problems," said Allen Sinai, chief global economist at Decision Economics Inc.

Poking through the gloom: energy prices have recently calmed down after hitting record highs just a few months ago. Inflation still remains high, but the retreat in energy and some other commodity prices does buy the Fed more time to see if the economy and financial markets improve on their own.

The Fed in June halted its most aggressive rate-cutting campaign to shore up the economy out of fears that those low rates were aggravating inflation. It didn't budge the rate at the last meeting in August for the same reason. Many don't think additional rate reductions would have done much to bolster the shaky economy anyway and would have made the inflation problem even worse.

"The recent drop in commodity prices has improved the policy choice facing (the Fed)," said Janet Yellen, president of the Federal Reserve Bank of San Francisco. "However, going forward, it is clear that we must keep a close eye on both inflation and inflation expectations to ensure that we continue to earn the inflation credibility that we have built up over the past two and a half decades," she warned.

To the end, the Fed has said that it's next move on rates is probably up -- to fend off inflation. However, most analysts don't believe that will happen until next year, given the fragile economic and financial conditions.

Against that backdrop, the Fed's rate is all but certain to stay at 2 percent when it meets Tuesday. And, in turn, the prime lending rate for millions of consumers and businesses would remain at 5 percent. The prime rate applies to certain credit cards, home equity lines of credit and other loans. Both the rate's key rate and the prime rate are at four-year lows.

Fed officials have suggested that harder-to-get credit and financial troubles have blunted the energizing impact of the Fed's rate cuts on consumers and businesses. Despite the Fed's cuts, mortgages rates had drifted upward. They was some relief, however, following the government's takeover of Fannie Mae and Freddie Mac, the country's largest sources of mortgage funding.

Rates on 30-year mortgages dropped sharply last week, falling to the lowest level in five months.

Worried about the economy and their own business prospects, employers have cut back hiring. The nation's unemployment rate zoomed to 6.1 percent in August, a five-year high. So far this year 605,000 jobs have been lost. The jobless rate could climb as high as 7 percent by the summer or the fall of next year, according to some projections.

With more people out of work, wage growth trailing inflation and the bracing impact of the government's tax rebates gone, consumers are likely to retrench later this year, spelling more trouble for the economy. A growing number of analysts predict the economy will actually shrink in the final three months of this year and perhaps in the first three months of next year, meeting a classic definition of a recession.

"Consumer spending is expected to get worse before it gets better," said Diane Swonk, chief economist at Mesirow Financial. Consumers are major shapers of overall economic activity.

Democrats, including presidential contender Barack Obama, support a second round of government stimulus to rev up the economy. Republican rival John McCain advocates tax cuts, free-trade and other measures to bolster business activity and job creation.

After two dismal quarters, economic growth improved in the spring, thanks to brisk exports and more shopping at home spurred by the rebates. But the rebound isn't expected to last. Slowdowns overseas will sap demand for exports in the coming months just as Americans hunker down.

Frugal shoppers cut back again in August, driving down sales at the nation's retailers for the second month in a row, further proof the economy is losing traction, the government reported Friday.

On the inflation front, Bernanke welcomed the recent retreat in energy and other commodity prices. Oil prices dropped from a record-high of $147.27 in mid-July to above $102 a barrel.

That helped calm wholesale prices in August. Wholesale prices dropped by the most in nearly two years, the government reported last week.

Bernanke and other Fed members have warned that even though they expect inflation to moderate, prices are still high. And, there's always the risk that prices could march upward again.

[Associated Press; By JEANNINE AVERSA]

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