Fed seen on hold as credit worries rise

The U.S. Federal Reserve is expected to hold overnight interest rates steady and reaffirm concerns about inflation at its meeting on Tuesday, but may also acknowledge emerging signs of economic weakness.

Fed policy-makers began meeting at 8:30 a.m. EDT against a backdrop of unsettled financial markets and were expected to announce their decision on interest rates in a statement at around 2:15 p.m. EDT.

The central bank faces the difficult task of acknowledging heightened uncertainty over the economy's path, while reassuring jittery markets the expansion is sound.

The interest-rate decision does not appear to be in doubt. The Fed looks certain to hold the benchmark federal funds rate at 5.25 percent, the level it was raised to in June last year.

But financial market participants will scour the Fed's announcement for any sign of anxiety that rising default rates in the U.S. subprime mortgage market and tightening corporate credit conditions could damage the economy.

As the meeting began, the Labor Department reported that second-quarter worker productivity grew at an annual rate of 1.8 percent, below forecasts. Unit labor costs that are taken as one gauge for inflation risks rose at a 2.1 percent rate that was modestly above expectations.

Following a strong stock market rally on Monday, stock futures turned lower after the productivity data was issued.

We think the Fed will walk a verbal tightrope, acknowledging the turbulence in financial markets and some additional risks to its growth forecast while maintaining a hawkish tone on inflation, said Michael Darda of MKM Partners.

In recent statements, Fed officials have said housing market weakness and financial market volatility have not spilled over into the broader economy, and they have held to their forecast of steady if somewhat sluggish growth through 2007.

The economy grew at annual rates of 0.6 percent in the first three months of the year, and 3.4 percent in the second quarter of 2007. The Fed's central forecast is for growth of between 2.25 and 2.5 percent for 2007.

At the end of last week, stocks plummeted on comments by a Bear Stearns official that credit market conditions were at their worst in two decades. However, stocks rose sharply on Monday as investors snapped up perceived bargains.

Fed Chairman Ben Bernanke and his colleagues may take note of growing concerns about credit risk and shrinking liquidity in the housing and corporate credit markets, some analysts believe.

While some think the Fed will go so far as to give equal weight to concerns about growth and inflation, many observers expect the Fed to remain focused on ensuring that core inflation, which excludes food and energy prices, moves convincingly lower.

The committee will move to gently ... reshape the language within the statement to rebalance the risks between growth and inflation due to recent events and poise it for future action should events in the real economy warrant a rate cut, said Joseph Brusuelas, chief U.S. economist at IDEAglobal.

Fed officials have warned in the past that investors may have underestimated the risks they were taking and policy-makers are unlikely to view financial market swings as reason alone to lower interest rates.

Fed officials are very aware that much of the difficulty coming to the surface today is the result of bad decisions made over the last few years and thus will not want to be seen as bailing out bad actors and creating moral hazard for the next financial crisis, economists at RBS Greenwich Capital wrote.

At the same time, inflation has shown signs of easing. By the Fed's favorite measure, core inflation drifted below 2.0 percent in June. Many Fed officials have said they would like to see inflation contained in a 1.0 percent to 2.0 percent range.

The Fed will also factor in the unimpressive 92,000 non-farm jobs created in July and signs of slowing service sector and manufacturing activity, all against the backdrop of bleak news from the housing market.

Policy-makers will be watching closely to see whether there is any broader retrenchment of consumer or business spending.

Although some Fed officials probably remain worried about inflation, we suspect that the recent news has made most members at least equally concerned about real activity, Goldman Sachs economist Jan Hatzius wrote.

(Additional reporting by Alister Bull)