August Stock Talk 2007

The Fed stood pat on short-term interest rates Tuesday but warned that inflation remains its chief concern in assessing the U.S. economic picture.

Stocks, which were up modestly at midafternoon heading into the 2:15 p.m. EDT release of the Fed decision, sold off as investors read the inflation comments as saying the Fed won't bail out hard-hit investors in the bond market. After being up about 40 points before the decision, the Dow Jones Industrial Average was off 51 points at 2:23 p.m.

"Economic growth was moderate during the first half of the year," the FOMC wrote. "Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing.

"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.

"Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

"Although the downside risks to growth have increased somewhat," the statement continued, "the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."

The Federal Open Market Committee's rate decision was widely expected on Wall Street. The move keeps the widely watched federal funds target rate at 5.25%. The accompanying policy statement indicates the Fed continues to view inflation as the greatest threat to the economy.

Action on Wall Street in the past week has focused in large measure on whether the Fed's statement would make a nod to the carnage in the housing and mortgage markets. Some investors believe the Fed could bolster investor confidence in the bond markets by indicating a readiness to intervene should a credit crunch threaten the broader economy. Others believe that the Fed is unlikely to do so because to reduce rates now risks bailing out speculators.

For that reason, investors have been keenly focused on the Fed's policy statement, which lays out the central bank's views on the greatest threat to the nation's economic health. At the Fed's meeting back on June 28, members of the FOMC said their "predominant policy concern remains the risk that inflation will fail to moderate as expected."

The news comes amid rising concern over the health of the U.S. debt markets. Investors over the last month have fled junk-rated debt of all stripes, widening the spreads between risk-free Treasury bonds and riskier paper. The widening spreads have caused the once-hot leveraged buyout pipeline to freeze, leaving big U.S. banks and brokerages facing the possibility of significant losses on their balance sheets.