Fed says inflation main worry, but cites risks

By Mark Felsenthal

WASHINGTON (Reuters) - The Federal Reserve on Tuesday held benchmark U.S. interest rates steady and said that while tightening credit conditions had increased downside risks facing the economy, inflation was still its main concern.

The decision by the central bank's Federal Open Market Committee kept the overnight federal funds rate at 5.25 percent, the level it hit in June 2006 after 17 straight quarter-percentage-point increases.

The Fed took note of recent turbulence in financial markets in announcing its decision, but said it believed the economy was sound. Stock prices closed higher on the Fed's optimism, while U.S. government bond prices fell as traders trimmed their expectations for interest rate cuts in coming months.

"Although the downside risks to growth have increased somewhat, the committee's predominant policy concern remains the risk that inflation will fail to moderate as expected," the central bank said.

"Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing," it said.

"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 Fed said.

Policy-makers met against a backdrop of volatile financial markets and rising default rates in the U.S. subprime mortgage market that had led some financial market participants to clamor for a reduction in borrowing costs.

Even after a big rebound on Monday and further small gains on the back of the Fed's announcement, stocks indexes are well below highs notched in mid-July, and investors have lost their appetite for riskier debt.

TOUGH LOVE FOR MARKETS

"It wasn't a hug from mom," Andrew Kanaly, chairman of Kanaly Trust Company in Houston, said of the Fed's statement.

"The markets are wanting to see them do something to help out the financial sector and the Fed is saying ... the rest of the economy is doing fine," he said.

The Fed at each of its three prior meetings had warned of the risk that inflation might not recede. But some analysts had thought financial stress could lead officials to put growth concerns on an equal footing with worries about price pressures.

Chances of a September rate cut, as implied by short-term interest rate futures contracts, dropped to 20 percent after the central bank's statement from 46 percent on Monday. Chances for an October easing fell to 52 percent from 84 percent.

The Fed said that while inflation outside volatile food and energy costs has improved modestly in recent months, it is not yet convinced that inflation is completely tamed.

As it had at its last meeting in June, the central bank warned that a tight labor market could push inflation higher.