Fed holds rates steady, but warns again on inflation

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Federal Reserve policymakers signaled today that they’re more worried about inflation than they were even six weeks ago -- but not worried enough, yet, to raise their benchmark interest rate. The weak economy is keeping the Fed on hold.

That’s good enough for the stock market: The Dow Jones industrial average, already up sharply before the Fed’s statement thanks to another drop in oil prices, quickly padded its gains. The Dow was up 280 points, or 2.5%, to 11,564.56 at about 12:30 p.m. PDT.

The Fed, at its regular mid-summer meeting, held its key short-term rate steady at 2%, as expected. The rate has been at 2% since April 30.

Chairman Ben S. Bernanke and peers have been aiming to support the struggling U.S. economy with low rates, but they’ve been challenged by rising inflation pressures that normally would call for tighter credit.

The Fed, in its post-meeting statement, nodded to both concerns, as it has at previous meetings this year.

Noting that ‘labor markets have softened further and financial markets remain under considerable stress,’ the statement said that ‘tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters.’

That was pretty much the same language the Fed used to describe the economic outlook at the last meeting, on June 25.

But the Fed at the last meeting also said that ‘downside risks’ to economic growth ‘appear to have diminished somewhat.’ It didn’t repeat that line in today’s statement, perhaps reflecting some of the more dire economic data in recent weeks -- including the jump in the unemployment rate to a four-year high of 5.7% in July.

Michael Darda, chief economist at investment firm MKM Partners in Greenwich, Conn. said the Fed appeared to be acknowledging that ‘downside risks had risen, without signaling that further [credit] easing would be on the way.’

The central bank’s inflation warning sounded a bit more urgent than the one at the last meeting.

Rather than mince words, the Fed came right out and said that ‘inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities.’

Although the statement said policymakers expected ‘inflation to moderate later this year and next year,’ it warned that ‘the inflation outlook remains highly uncertain.’

That wasn’t enough for one member of the Fed’s policy-making committee: Richard Fisher, president of the Fed’s Dallas branch, for the second straight meeting argued to raise the central bank’s key rate to combat inflation. He was outvoted 10 to 1.

Some Fed-watchers speculated that Bernanke agreed to a tougher warning on inflation to keep some other committee members from pushing for an immediate rate hike.

‘This may have been a sufficient bone to the [inflation] hawks to prevent others from joining Fisher in dissenting,’ said Marc Chandler, head of foreign currency strategy at Brown Bros. Harriman & Co. in New York.

The Fed is getting some help on inflation, with prices of oil and many other commodities falling sharply over the last month. Crude futures today slid $2.24 to $119.17 a barrel in New York, after diving $3.69 on Monday. Oil now is back to where it was in early May, and down 18% from the peak of $145.29 reached on July 3.