Fed leaves US rates unchanged at 1.25%

The Federal Reserve left short-term interest rates unchanged yesterday, but set the stage for a cut if the economy shows no sign of improvement when policymakers next meet in June.

Given the fluid state of the economy, the decision to hold the overnight federal funds rate at a 41-year low had been expected by traders. But the central bank issued a surprise, if veiled, warning of the risk of deflation, where falling prices drive the economy into a downward spiral.

The "balance of risk" was weighted towards weakness for the foreseeable future, the Federal Open Market Committee said, downgrading its assessment of the economy from the neutral stance adopted at its last meeting.

And in a key passage of its statement, the FOMC warned that "the concern of the possibility of an unwelcome and substantial fall in inflation, though minor, exceeds that of a pick up in inflation".

The central bank's decision to hold rates had been signalled by Alan Greenspan, when the Fed chairman told Congress last week that economic growth would be at "a noticeably better rate" later this year, now that uncertainties over Iraq have been lifted and oil prices are easing.

With the key overnight funds rate already at just 1.25 per cent, after the 0.5 per cent cut last November, the Fed has little ammunition in its locker.

But analysts warn that if the economy remains in the doldrums, the next FOMC meeting, scheduled for 25 June, will see another cut in borrowing costs.

Several regional presidents, including those of the Chicago and San Francisco reserve banks, have recently suggested that the economy's problems run deeper than worries over war with Iraq, implicitly calling for a more aggressive monetary policy.

Though signs are emerging of improving consumer confidence and higher factory output, GDP growth was a feeble 1.6 per in the first quarter, barely higher than the 1.4 per cent of fourth quarter 2002.

President George Bush too is banking on an upturn in the economy, as he prepares for the 2004 election campaign. He is lobbying for his $550bn tax package, the centrepiece of the White House growth strategy.