Fed holds rates steady, spurning calls for cuts

By Mark Felsenthal

WASHINGTON (Reuters) - The Federal Reserve held U.S. interest rates steady on Tuesday and showed little inclination to lower them soon, spurning calls for cuts from financial markets roiled by the bankruptcy of investment bank Lehman Brothers Holdings Inc.

The central bank's unanimous decision left benchmark overnight rates at 2 percent, a level reached in April.

"Downside risks to growth and the upside risks to inflation are both of significant concern," the Fed said, surprising many analysts who thought recent market shocks would help policy-makers set aside earlier concerns on price pressures.

"To read their statement, you would never know the sky has fallen in on Wall Street," said Ian Shepherdson, chief U.S. economist at High Frequency Economics. "This statement is either very brave or very reckless. Not to acknowledge the catastrophes ... runs the very serious risk that the Fed will be seen as Nero, fiddling while Wall Street burns."

Investors had begun to bet this week that the Fed would lower rates to help settle financial markets upended by the bankruptcy of 158-year-old Lehman Brothers, the sale of investment bank Merrill Lynch to Bank of America, and a scramble for cash by insurer American International Group Inc.

Stocks fell after the Fed's decision but later rose on a Bloomberg news report that the Fed was considering a loan package for AIG. The Dow Jones industrial average closed up 141 points, or 1.3 percent, while the dollar gained on the euro and U.S. government bond prices fell.

"Strains in financial markets have increased significantly and labor markets have weakened further," the Fed said. "Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters," it added.

The central bank said already-low rates and steps it has taken to ease funding strains in credit markets should help to promote growth over time.

PUSHING ON A STRING?

Some said that a rate cut would do little good when cash-starved banks lack the capital to lend.

"It may be psychologically nice if they want to play day games with the stock market, but why (would) they want to do that?" asked George Feiger, chief executive at Contango Capital Advisors in Berkeley, California.

The shock of recent financial events has caused banks to recoil further from lending, threatening to exacerbate a credit crunch that has pushed the U.S. economy toward recession.

On Sunday, the Fed said it would accept a wider range of collateral from investment banks seeking central bank loans and pad the size of some of its market auctions to try to keep credit flowing. On Monday and Tuesday, it flooded interbank lending markets with funds, at times pushing benchmark rates well below the 2 percent target.

As Fed officials met, talks aimed at helping AIG through its cash crunch entered a second day at the New York Federal Reserve Bank. Officials from the Fed, U.S. Treasury and New York state and financial firms were involved.

New York Fed President Timothy Geithner skipped the Fed's rate-setting meeting to stay in New York to monitor developments.