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Fed Opens the Door to Future Rate Cuts

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RISMEDIA, March 23, 2007-(WSJ.com)-The Federal Reserve formally dropped its stated bias to raise interest rates, giving itself flexibility to cut interest rates in coming months if economic growth decelerates further.

As expected, the central bank left its target for the federal funds rate, charged on overnight loans between banks, at 5.25%, where it has stood since June. The Fed also continued to cite concerns about inflation.

In discussing its inclination on where to move interest rates next, the Fed said, "Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth," a more neutral description than prior months' reference to the possible "additional firming," or higher rates. The Fed also called inflation its "predominant" concern, implicitly recognizing it had other concerns about growth.

"This statement is clearly a move toward neutral but, if one takes [Fed policy makers] at their word, not quite neutral," J.P. Morgan Chase Economist Michael Feroli said in a note to clients.

Indicators on economic growth "have been mixed," the Fed said, less optimistic than its reference at its last meeting, in January, to signs of "firmer economic growth." Inflation, it said, has been "somewhat elevated," compared with January's reference to modest improvement. But it reiterated its expectation that growth would remain moderate and inflation would move lower.

Markets immediately concluded that chances had increased for a rate cut in coming months. Futures markets raised the odds of a quarter-point rate cut by midyear to 44%, from 24% before the meeting. Bond prices rose, and yields, which move in the opposite direction, fell. Stocks soared, as the Dow Jones Industrial Average rose 159.42 points, or 1.3%.

Ten of the Fed's 11 sitting policy makers voted in favor of keeping rates on hold. Governor Susan Bies, who is stepping down soon, didn't attend. One of the 12 seats is vacant.

The Fed's change in stance came as a surprise; economists had generally expected the Fed to tweak its description of the economy while leaving its interest-rate bias unchanged. Some were puzzled by the move.

"We see the change as reflecting a 'cleaning up' of the risk-assessment language that carries little policy significance," David Greenlaw, an economist at Morgan Stanley, said in a note to clients. But he wondered why the Fed would do that, since it must have known markets would see it as a deliberate signal on future rate moves.

Some observers said Fed Chairman Ben Bernanke is coming to the rescue of the markets, in this case the subprime-mortgage market, much as his predecessor, Alan Greenspan, did when stocks plunged in 1987 and 1998. "The Federal Reserve 'put'…has now passed into the hands of Chairman Bernanke," Neal Soss, chief economist at Credit Suisse, said in a note to clients. A "put" option gives the holder protection against the decline in value of an underlying asset.

Since last fall, markets have been consistently less optimistic than the Fed about economic growth and more optimistic about inflation. As a consequence, markets had priced in as much as three quarter-point rate cuts by the end of 2007, even as Fed officials professed a continued concern about inflation.

In recent months, however, the divergence has begun to close. Repeated Fed concerns on inflation coupled with low unemployment readings dissuaded investors from expecting immediate rate cuts. But at the same time, economic growth has slowed, to a little over 2% at an annual rate, in the past year, much as the Fed expected. That slowdown has been led by a retreat in housing construction, much as the Fed expected. But in recent months, officials have been surprised by the sluggishness of business investment. Business spending has been expected to take some of the slack left by declining home building.

While core inflation, which excludes food and energy prices, crept higher in January and February, Fed officials still expect it to recede this year.

They cite several reasons: the fading, indirect impact of energy prices and the flattening out of home-ownership costs as rent rises slowly.

Because the Fed tries to set interest rates with a view to where growth and inflation will be in six to 18 months, decreased confidence in growth and increased confidence in lower inflation may have raised a desire to open the door to rate cuts in coming months.

Ian Shepherdson, chief U.S. economist at High Frequency Economics, said it is normal for inflation to ease when an economic expansion is decelerating — and for the Fed to show "equivocation." When the Fed's expectation of "moderate" growth fails to materialize, he said, "expect rapid easing" with the first cut by August.

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