Federal Reserve Keeps
Interest Rates Unchanged

While acknowledging turmoil in financial markets and worries about a looming credit crunch, the Federal Reserve kept its key interest rates unchanged and said its "predominant policy concern" remains inflation.

"Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing," the Fed said in a statement. "Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy."

The unanimous decision of the Fed's policy committee leaves the benchmark federal funds rate, the rate at which banks lend to each other overnight, at 5.25%, where it has been since June 2006.

Many economists expect the key Fed rate to remain there for the next few months despite the persistence of the housing slump and the deterioration in credit markets in the past few weeks. Following the Fed's statement, financial future markets lowered the odds of a rate cut this fall -- putting the odds of a quarter-point cut in September at just 5% down from 35% before the announcement. But futures markets anticipate a rate cut before year-end.

The Fed said Tuesday, as it did in June, that inflation readings "have improved modestly," but it emphasized that "a sustained moderation in inflation pressures has yet to be convincingly demonstrated," precisely the same phrase it used in June.

The Fed's preferred inflation gauge -- the price index for personal consumption expenditures excluding food and energy -- has been running at a 1.9% annual rate through June. It was as high as 2.5% in February. The Fed doesn't have an official inflation target, but has long been assumed to have a comfort zone between 1% and 2% for core PCE.

Some Wall Street firms including Goldman Sachs and Miller Tabak had predicted the Fed would adopt a neutral stance at Tuesday's meeting, saying risks of slowing growth and rising inflation were now balanced. Fed Chairman Ben Bernanke repeated the Fed's inflation concerns three weeks ago when he testified to Congress. As recently as Thursday, when credit worries were front-and-center, Fed governor Randall Kroszner told lawmakers that economic fundamentals were "unchanged" from when Bernanke testified.

Officials on Tuesday repeated their concerns about "the high level of resource utilization" -- a reference to the still low unemployment rate and high industrial capacity-utilization rate.

In the minutes of their June meeting, released last month after the customary lag, officials also cited elevated energy and commodity prices, slower productivity and the declining value of the dollar. All three are likely still factors in Fed thinking even though they weren't mentioned explicitly in the new statement.

Complicating the Fed's task are new data suggesting it may be losing a key ally in its effort to maintain strong economic growth without inflation: Productivity, or output for each hour of work. Productivity grew at 1.8% pace in the second quarter, the Labor Department said Tuesday, but previous years` numbers were revised down as a result of earlier downward revisions to the total output in the economy.

In the first quarter, productivity grew at a 0.7% pace, down from the previous 1% and well below the torrid rates of earlier in the decade. Non-farm business productivity is now estimated to have grown just 1% in 2006, the slowest since the productivity surge began in 1995 and below the previous estimate of a 1.6% increase. Productivity growth in 2004 and 2005 were each revised down by 0.2 percentage point.

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