With the white-hot U.S. economy showing signs of slowing, Federal Reserve policy-makers did as expected yesterday and left borrowing costs unchanged - while warning that future interest-rate increases were possible if inflation accelerates in the months ahead.
"They're still showing signs of caution," said Maureen Allyn, chief economist for Scudder Kemper Investments in New York. "They're not giving the all-clear signal."
That caution didn't help stocks: Investors had hoped that the Fed might soften its stance and hint at potential interest-rate cuts in the not-too-distant future.
The Dow Jones industrial average rose 19.61 points, or 0.18 percent, to end the day at 10,719.74, though it had been up by as much as 1.5 percent before the Fed announcement. The Nasdaq erased a 1.4-percent gain to drop 113.07 points, or 3.17 percent, the largest drop since July 28. It closed at 3,455.83.
"We're facing slower profit growth and no relief from [higher] interest rates, and that's not good for stocks," said Irene O'Neill, manager of the Evergreen Income Fund.
At its meeting yesterday, the central bank's policy-making Federal Open Market Committee left the benchmark federal funds rate at 6.5 percent, a level reached May 16. It was the third straight meeting that the FOMC opted to leave the fed funds rate unchanged.
The federal funds rate - also known as the overnight rate - is what Fed member banks charge one another for overnight loans. It helps establish the borrowing rates on loans for cars, homes and other consumer purchases.
By raising or lowering this key rate, the Fed can help speed up - or slow down - the rate of overall economic growth. Concerned that the record-length U.S. expansion would overheat the economy - spawning inflation - the FOMC increased the fed funds rate by 1.75 percentage points in a series of increases starting June 30, 1999.
In keeping with the data of recent weeks, more evidence emerged yesterday showing that the U.S. economic engine is decelerating. The Index of Leading Economic Indicators dropped by 0.1 percent in August, the fourth straight monthly decline, according to the Conference Board.
The decline of this index - which attempts to forecast economic trends for the next three to six months - met analysts' expectations. Except for a 0.1 percent increase in March, the index has been flat or down throughout the year.
In a separate report, the Commerce Department said sales of new homes dropped 3 percent in August, even though mortgage rates have declined, though experts were quick to say that overall sales remain strong.
"The flat pace in the leading indicators points to continued moderation in U.S. economic activity, said Ken Goldstein, a Conference Board economist. "The economy is starting to reflect the impact of growth restraints. Interest rate and growth restraints will determine how much slower the economy will be in the last few months of the year."
For the central bank, the main concern remains the risk of inflation, the potentially ruinous upward spiral in prices that puts the pinch on consumers' pocketbooks.
Even though the American economy grew at a 5.6 percent annual clip in the second quarter, the Fed's key inflation fears center upon high energy prices, which pose "a risk of raising inflation expectations," the FOMC said in its statement yesterday.
Crude oil prices remain close to a decadelong high - having nearly tripled over the past 18 months. To date, these higher costs haven't translated into inflation, having only a "limited effect on the core measure of prices," the Fed statement said.
Even so, "the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future," the statement said.
Some economists say the militant language is just more jawboning by the Fed - one of the tools it uses to influence the economy, as well as the stock and bond markets - since there is less evidence of inflation now than there was when the central bank last raised interest rates - in May.
"When all is said and done, inflation is low," said Neal Soss, an economist with Credit Suisse First Boston in New York.
Some economists are hoping - despite its tough talk - that the Fed will start loosening credit in the first part of next year. "I think the next move is going to be an easing," said Tim Rogers, chief economist of Briefing.com in Boston.
Wire services contributed to this article.
