Fed surprises markets by holding interest rates

The US Federal Reserve yesterday took world financial markets by surprise by deciding to leave American interest rates unchanged.

The decision to hold the Federal funds rate at 5.25 per cent, where it was set on 31 January, and the discount rate at 5 per cent signalled the Fed's belief that inflationary pressures within the economy were still well under control.

Markets had been braced for a quarter-point increase, but political as well as economic factors clearly stayed the central bank's hand.

Traditionally the Fed, anxious to underline its political neutrality, does not change rates in the run-up to a presidential election, now just six weeks away. On this occasion it seems to have judged that, despite strong first-half growth, wages and prices were showing no untoward increases. "There has been no evidence of price pressure," said economist Robert Diderich.

But even in economic terms, Fed chairman Alan Greenspan and his colleagues had to weigh conflicting factors. Despite a steady inflation rate of just under 3 per cent, unemployment has dropped to just 5.1 per cent, and continuing growth in hourly wage rates has worried some analysts.

Before the meeting senior Fed officials were split, as evidenced by a detailed leak - which the FBI has been called in to investigate - that eight of the 12 regional banks in the Federal Reserve System favoured a rate increase, with three of them calling for a full half-point hike in the Federal funds rate.

In contrast to the regional bank governors, traditionally inflation-hawks, the political appointees on the Fed board were less concerned that the economy, despite 4.8 per cent second-quarter GDP growth, is about to overheat. This camp seems to have won the day.

Shortly after the Fed's announcement, bonds showed solid gains, but the Dow was on a roller-coaster - moving from minus 31 points to plus 34 points minutes after the announcement and then swiftly back into negative territory. It ended down 21points at 5874.0.

Also influencing the market was a sombre earnings forecast from AT&T, and a slight dip in the closely watched consumer confidence index in August. Since February 1995, the Fed has not raised rates. Since then it has trimmed the Federal funds rate three times by a quarter point.

US analysts, a majority of whom had expected a rate rise, were last night at odds over the merits of the Fed's decision.

Philip Orlando, chief investment officer at Value Line Asset Management said the Fed's decision was "fully justified given the complete absence of inflation". But Graham Tanka, president of Tanka Capital Management, said he was disappointed that the Fed had not taken "a golden opportunity to nudge rates on" as a pre-emptive strike against inflation.

Nervousness in the London markets ahead of the Fed's announcement was eased to some extent by good economic news on the domestic front.

A sharp improvement in Britain's trade balance gave the Government a further boost while other figures showing better-than-expected growth earlier this year were seen by economists as effectively ruling out further cuts in UK interest rates.

The news bolstered the pound, but had little impact on the stock market which closed with the FT-SE 100 index 9.2 points lower at 3,910.5.

The UK statistics showed a balance of payments surplus of pounds 457m between April and June, compared with City forecasts of a deficit of around pounds 1bn. In addition, a trade gap of pounds 1.1bn in the first quarter of the year was revised down to pounds 0.8bn. The improvement came from the trade surplus from investment income, which rose from pounds 2.4bn between January and March to pounds 4bn.