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Fed seen holding rates steady as growth stumbles

WASHINGTON (Reuters) - The U.S. Federal Reserve on Tuesday began a one-day meeting at which it is expected to hold interest rates steady amid poor housing and credit conditions, while signaling inflation concerns even as oil prices ease.

Police officer Joseph Washington secures the area near the Federal Reserve Building in Washington June 25, 2008. REUTERS/Yuri Gripas

A statement from the Fed’s newly expanded Federal Open Market Committee outlining its decision and thinking on the economy is due around 2:15 p.m. (1815 GMT).

Just before the meeting started, the Fed swore in veteran community banker Elizabeth Duke as a new board member who will vote on Tuesday’s policy decision.

The action may give Fed Chairman Ben Bernanke a valuable ally on interest-rate policy at a difficult juncture.

With commodities prices soaring, Bernanke has faced several dissents in recent months from regional Fed bank presidents favoring higher rates. While little is known about Duke’s views on monetary policy, Fed board members rarely dissent.

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 at their June meeting, when they said they 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 federal funds rate steady at 2 percent at its June 24-25 meeting, 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 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.

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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.

SERVICES CONTRACT SLIGHTLY

As the Fed was meeting, a key measure of the U.S. services sector showed the sector shrank slightly in July, though by less than economists had forecast.

The Institute for Supply Management said its non-manufacturing index was at 49.5 for July compared with 48.2 for June. A reading below 50 signals contraction, and economists polled by Reuters forecast the index at 48.5.

The service sector represents about 80 percent of U.S. economic activity, including businesses such as banks, airlines, hotels and restaurants.

The Fed must also factor continuing credit strains into its outlook. A weakened banking sector continues to tighten lending, suggesting less credit will 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.

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,” Lehman Brothers economist Michael Hanson wrote in an analysis.

The Fed “is likely to continue with hawkish rhetoric, reiterating its vigilance against inflation but also noting 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 and Bernanke could face dissents from one or more officials against any decision to hold rates steady.

“We’re 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 latest 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.

Additional reporting by David Lawder, Editing by Chizu Nomiyama

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