The Wall Street Journal

The Federal Reserve brought its aggressive campaign of interest-rate cuts to a close on Wednesday, expressing heightened concern about inflation and effectively suggesting that its next move — though hardly imminent — is likely to be a rate increase.

The central bank’s policy committee held its target for the federal-funds rate, charged on overnight loans between banks, at 2%. The decision marked the first time since the credit crisis flared last August that officials voted not to cut the target.

In a statement, the Fed displayed more concern about inflation risks while backing off modestly from worries about growth. The policy committee maintained its view that “uncertainty about the inflation outlook remains high,” because of continued price increases for energy and other commodities and “the elevated state” of some indicators of inflation expectations.

“Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased,” the Fed said.

The statement suggested that Fed officials would continue trying to balance the twin risks of stubborn inflation and continued weak growth through the rest of the year. As a result, an interest-rate increase is probably not imminent, though it can’t be ruled out if the inflation problem worsens.

U.S. stocks initially surged on the news but then retreated. The Dow Jones Industrial Average, up almost 117 points at its high, ended the day up 4.40 points to 11811.83. It’s down 11% for the year. The dollar declined after the rate decision on the indication that the Fed is not eager for a rate increase, which could tend to draw overseas funds to the dollar.

Fed policy makers meet next on Aug. 5. The measured language of their statement Wednesday suggests no current inclination to raise rates at that meeting. But officials will get more data on inflation and the condition of the labor market before the meeting occurs.

Futures markets expect at least a quarter-point rate increase by the end of October and are putting a 38% chance on an August increase, down from 67% earlier in the day. Few economists expect the central bank to start raising rates before late this year or early next year, at least until there’s improvement in the housing, credit and labor markets.

Inflation Psychology

However, a rapid worsening in inflation expectations could spur the Fed to act quickly out of fear of allowing an inflation psychology to take hold with the public. And a sharper slowdown in growth, beyond the recent weak readings, could add more caution if the numbers are worse than officials expect.

One clue may have come from the Fed’s statement Wednesday, which removed language from its April statement suggesting recent improvement in the underlying inflation rate, that is, the rate excluding food and energy. Officials laid out an expectation for inflation to moderate “later this year and next year” rather than in “coming quarters,” as it had said in April; that was a time frame that may signal how long officials are willing to wait before increasing short-term rates. “It’s almost a marker that they’re putting down,” said Tom Gallagher, an analyst at ISI Group.

At the same time, the Fed expressed concerns that tighter credit, the housing slump and rising energy prices could weaken economic growth even further. That suggests an interest-rate cut later this year isn’t entirely off the table if the economy deteriorates significantly.

“They’ve definitely moved the needle a little bit from growth toward inflation,” said J.P. Morgan economist Michael Feroli. But the statement “gives them enough wiggle room down the line that it’s pretty amenable to a lot of economic outcomes.”

The vote to hold the fed-funds target rate steady was 9-1. Richard Fisher, president of the Federal Reserve Bank of Dallas, cast his fourth straight dissent this year. He wanted an increase.

The move ended a nine-month easing cycle that included seven interest-rate reductions, bringing the rate target down from 5.25% in one of its most rapid rate-cutting cycles ever. As financial markets tumbled amid tumultuous economic conditions around the world, the Fed took a series of unconventional steps through new lending programs for banks and coordination with foreign central banks.

Its Wednesday decision to stand pat contrasts with actions in recent weeks by a number of central banks abroad that have started raising interest rates amid inflation concerns stemming largely from price surges for food, energy and other commodities. The U.S. economic outlook, however, is more fragile and inflation judged to be less threatening.

The European Central Bank next week is expected to raise its rate target to 4.25% from 4%. Its president, Jean-Claude Trichet, told the European Parliament on Wednesday that the goal is to keep inflation expectations under control. He said officials there are in a state of “heightened alertness” and are particularly worried about a potential inflation spiral, in which workers seek higher wages and businesses raise their prices.

Fed officials are watching closely for any signs of a wage uptick that could signal the start of such a spiral. Overall inflation — as measured by the Fed’s preferred inflation measure, the price index for personal consumption expenditures — is running at more than 3% because of continued spikes in energy prices. However, the “core” rate, which excludes volatile food and energy prices, remains just above 2%. Fed officials define price stability as inflation of 1.5% to 2% annually, though that level has not been attained consistently for four years.

For now, Fed officials want to avoid an increase in the short-term rate they control, which could exacerbate the weakness in employment, financial markets and the housing sector. They’re also trying to signal they’re serious about fighting inflation by talking about the risks of rising inflation expectations and suggesting a willingness to act quickly if inflation expectations get out of hand.

Some measures of inflation expectations suggest considerable public angst. A survey released this week by the Conference Board, a business research group, puts consumers’ expectation for the inflation rate over the next year at 7.7%, up from 5.4% a year ago.

‘Standard Playbook’

“The standard playbook for almost any central bank indicates that a rise in inflation expectations should be met with tough rhetoric,” Morgan Stanley economist David Greenlaw said in a note to clients, He added that Fed officials stepped up their jawboning on inflation a few weeks ago. “If the economy improves or inflation expectations continue to rise, they are likely to be forced to act,” Mr. Greenlaw said.

Fed Chairman Ben Bernanke may help clarify the conditions under which a rate increase may be expected when he delivers his semiannual testimony before Congress in July.

Many officials expect the weak economy, particularly the rising unemployment rate, to restrain wages and ease inflation — if commodity prices level out.

Though the risk of a severe downturn, a prime concern earlier this year, has diminished, the economy remains under intense pressure. Surging fuel prices, besides aggravating inflation, are weighing on consumer spending and threatening to exact deeper damage on an economy that’s barely growing.

Consumer confidence has continued declining in June, according to the Conference Board, and a measure of consumers’ expectations for the economy six months ahead tumbled to the lowest since the group began its surveys over four decades ago.

For now, $110 billion of rebate checks flowing to consumers from the U.S. government’s economic-stimulus program is propping up retail sales and potentially cushioning the economy into the autumn. But business investment is flattening, and there’s little expectation of an improvement anytime soon.

Employers continue to reduce jobs. The U.S. Labor Department next week is expected to report that nonfarm payrolls declined in June for the sixth straight month. Fed officials expect the unemployment rate to rise from the current 5.5% by the end of the year.

The housing market shows few signs of hitting bottom. U.S. house prices are declining at an accelerating pace and are down almost 18% from their July 2006 peak as measured by the S&P/Case-Shiller 20-city index. Inventories remain high and analysts say new-home construction is likely to fall further before the market is back in balance. The Fed’s decision to hold rates steady could prevent mortgage rates from rising further and help pull home buyers into the market.

The financial sector, meanwhile, has shown improvement, partly because of several new lending programs created by the Fed for banks. But longer-term interest rates have been rising in recent weeks, a development that could keep pressure on the overall economy even without rate increases from the Fed.