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Fed keeps federal funds rate unchanged at 5.25 percent

WASHINGTON—The Federal Reserve paused Tuesday after more than two years of 17 consecutive interest-rate hikes, but it cautioned that the break might be temporary and that future rate hikes may be needed if inflation doesn't subside.

"The extent and timing of any additional firming . . . will depend on the evolution of the outlook for both inflation and economic growth," the Fed's policy-making body, the Federal Open Market Committee, said in a statement.

The Fed's decision to leave its benchmark "federal funds" rate at 5.25 percent is good news for borrowers who have adjustable-rate mortgages and variable-rate lines of credit or credit cards. Bank rates for these loans are generally pegged to the fed-funds rate, the overnight rate that banks charge each other. They'll now take a breather after more than two years of climbing.

When the Fed began its credit-tightening cycle in June 2004, the fed-funds rate was 1.0 percent. The prime rate—what banks charge their best customers—was 4.22 percent, home-equity lines of credit were 4.68 percent, and a one-year adjustable rate mortgage was 4.25 percent.

Since then, as the fed-funds rate rose to 5.25 percent, banks raised those rates, respectively, to 8.25 percent, 8.74 percent and 6.16 percent. Consumers owing those loans have to pay much more in interest to service their debts.

While the Fed's pause Tuesday was welcome news for consumers, it fell far short of a declaration that the credit-tightening cycle has peaked. Soaring energy prices, strong global demand for commodities and rising labor costs all increase the risk that inflation, or rising prices across the economy, will grow worse in the months ahead, forcing the Fed to react further.

The Fed's primary mission is to keep a lid on inflation. It does that primarily by lifting interest rates to slow economic activity.

But conducting monetary policy is a little bit like landing a plane with your eyes closed, because there's generally a lag of six months or more before the effects of interest rate increases are visible across the economy. The Fed gambled Tuesday that its previous rate hikes and the slowing economy are enough to contain inflation. But some analysts fear that those 17 previous rate hikes will slow the economy right into recession by next year.

"It's a balancing act they've got right now. Certainly they haven't had this situation in many, many years," said Richard S. Fedele, the CEO of Summit Mortgage, a privately held, Boston-based mortgage-banking firm.

Second-quarter statistics show that the U.S. economy grew by only 2.5 percent from April to June, down sharply from the 5.6 percent annual pace between January and March. That argues against more rate hikes.

But energy prices, the main inflationary threat, keep rising. And on Tuesday, new Labor Department data showed that labor costs rose at a 4.2 percent annual rate in the second quarter. Meanwhile productivity, or a worker's output per hour, rose by 1.1 percent after growing 4.3 percent from January to March.

Slowing productivity cuts into profits. Firms must then raise the prices of their goods or services to finance employees' pay raises. Voila, inflation.

For the first time since Fed Chairman Ben Bernanke took the reins on Feb. 1, there was a dissenting vote on the policy-making board. In only the fourth dissent since the Fed began publishing dissenting votes in 2001, Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, argued that inflation threats warranted another quarter-point hike.

But Bernanke and 10 other committee members expected that inflation threats would be muted by slowing economic growth, "partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices."

Many analysts expect inflation worries to prompt more rate hikes later this year, perhaps as early as the next committee meeting on Sept. 18.

"The inflation problem is going to get worse before it is going to get better," said Brian Bethune, U.S. economist for the consultancy Global Insight in Lexington, Mass. "We think the Fed will likely elect to raise interest rates one more time."

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(c) 2006, McClatchy-Tribune Information Services.

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