Fed holds rates steady as economy cools

Signs that the American economy is cooling down persuaded the US federal reserve to keep interest rates on hold yesterday.

The decision by the US central bank to keep the cost of borrowing steady at 6.5% was widely expected, after it raised rates sharply last month.

Wall Street rallied on the news. The Dow Jones industrial average rose 1% after the announcement, while the Nasdaq composite index, hit hard by six rate increases in the past 12 months, gained almost 3%.

The Fed said the economy was slowing but it was watching for signs of inflation. "Recent data suggest that the expansion of aggregate demand may be moderating toward a pace closer to the rate of growth of the economy's potential to produce," its statement said.

Since May's 0.5% rise in rates, unemployment has risen from 3.9% to 4.1%, retail sales have slowed and house prices rises have moderated.

With the economy growing at an annual pace of 5.4% in the first quarter, analysts are reluctant to declare that the next rates move will be down.

"This means the market will shift its focus to the August 22 meeting," said Phil Orlando, chief investment officer of Value Line Asset Management. "We do think at this point there will be a 25 basis point tightening at that time but that will be the end of the tightening cycle."

Orders to US factories for big-ticket goods shot up in May, a sign that the slowdown may be a mirage. "The manufacturing sector is not cooling off anywhere near as much as previously believed," said Mark Vitner, economist at First Union.

Policymakers on both sides of the Atlantic are concerned that overconfidence may be pushing share markets dangerously high. The Bank of England today warns investors of the risk of a sharp correction. "Equity markets in general and hi-tech stocks in particular continue to be highly valued on conventional measures," the Bank says in its biannual report on the stability of the financial sector.