Fed seen holding rates steady as growth stumbles

By Mark Felsenthal

WASHINGTON (Reuters) - The U.S. Federal Reserve on Tuesday is expected to hold interest rates steady as dismal housing markets and tight credit weigh on the economy, while it signals lingering inflation concerns despite lower oil prices.

A statement from the Fed's policy-setting Federal Open Market Committee outlining its decision and thinking on the economy is due around 2:15 p.m.

Facing the highest U.S. unemployment rate in four years and the lowest existing-home sales pace since early 1998, policy-makers will be more downbeat about the growth outlook than they were in June, when they said saw risks tapering off.

"The mention in the last statement that downside growth risks appeared 'to have diminished somewhat' now looks like a premature conclusion," JPMorgan economist Michael Feroli wrote in a note to clients.

The Fed held the interbank fed funds rate steady at 2 percent at its last meeting June 24-25, and has suggested it hopes rate reductions totaling 3.25 percentage points since mid-September will be enough to help the economy rebound.

While growth in gross domestic product growth in the April-June period was a relatively strong 1.9 percent, many economists expect activity in the latter half of the year to weaken as consumer spending spurred by government stimulus checks fades.

In addition, signs that growth in economies around the world may be slowing is an ominous sign for U.S. exports, which have been one of the few areas of strength.

The Fed must also factor continuing credit strains into its outlook. A weakened banking sector continues to tighten lending, suggesting that credit will not be available to support the economy in months ahead.

The U.S. central bank's recent decision in coordination with European and Swiss monetary authorities to extend and expand extraordinary credit facilities for banks and securities firms underscores policy-makers' concerns about the financial climate.

"The extension and enhancement of the liquidity facilities suggests the Fed remains concerned about financial stability, and thus is unlikely to raise rates in the near term," Lehman Brothers economist Michael Hanson wrote in an analysis.

Oil prices that have receded from a record high of over $147 a barrel reached in July may provide a little breathing room for the Fed, which in June said risks that inflation could tick higher had increased. On Monday oil prices fell below $120 a barrel for the first time since May 6.

"With oil and commodity prices not growing nearly as rapidly as earlier this year, headline inflation rates are set to moderate by the end of the year," Hanson wrote.

The Fed "is likely to continue with hawkish rhetoric, reiterating their vigilance against inflation but also noting that their expectation that slack in the economy should help mitigate inflationary pressures over several quarters," he added.

However, consumer price inflation, which reached 5 percent over the 12 months to June, is unacceptably high to the Fed. One or more officials may dissent against any decision to hold rates steady on Tuesday, a sign of unusual uncertainty over the outlook for prices.

"We are pretty well positioned for the downside risks we might encounter from here," Minneapolis Fed President Gary Stern said on July 18. "I worry a little bit more about the prospects for inflation."

The Fed, which has been patient with higher-than-desirable inflation to date because it believed inflation expectations remained anchored, got some welcome news in the Reuters/University of Michigan survey that showed inflation expectations over five years had eased.

"This meeting statement will likely do more to cement the notion of a Fed on hold for the long haul, as inflation risks stabilize but growth risks fail to abate further," Feroli said.

(Editing by Leslie Adler)

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