Fed: European debt crisis could endanger U.S. economic recovery

WASHINGTON -- The Federal Reserve struck a more cautious tone about the strength of the U.S. economic recovery, indicating Europe's debt crisis poses a risk to it.

Wrapping up a two-day meeting Wednesday, the Fed in a 9-1 decision retained its pledge to hold rates at record-low levels for an "extended period." Doing so is intended to energize the rebound.

The Fed expressed confidence that the recovery will stay intact despite threats from abroad and at home. But chairman Ben Bernanke and his colleagues offered a slightly more reserved outlook than the last time they convened.

The Fed said the economic recovery is "proceeding." That was a bit less upbeat than the view at the April meeting when the Fed said economic activity continued to "strengthen." The Fed also said the labor market is "improving gradually."

While not mentioning Europe by name, the Fed said "financial conditions have become less supportive of economic growth ... largely reflecting developments abroad."

The economic picture increases pressure on President Obama and lawmakers in Washington. Near-double-digit unemployment is certain to factor into the way Americans vote in congressional midterm elections this fall. If it fails to come down after that, the jobless rate could play a role in the 2012 presidential election.

At the same time, the president has limited options. Congress has run into opposition on extending unemployment benefits and providing more aid to cash-strapped states. While some liberal Democrats maintain government spending is the best way to stimulate the economy, a growing number of moderate and conservative Democrats share Republican concerns that the government's budget deficits pose a greater risk.

The subtle shift in the Fed's outlook drew little reaction from stock investors. The Dow Jones industrial average was essentially flat after announcement.

The decision to keep rates at record lows boosted demand for safe-haven assets like Treasury's, sending interest rates lower. The yield on the 10-year Treasury note, a widely used benchmark for mortgages and other consumer loans, fell to 3.13 percent from 3.25 percent late Tuesday. The 10-year note hasn't closed at that level in more than a year. Rates had already fallen earlier in the day after the government said new-home sales dropped 33 percent last month.

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, for the fourth straight meeting was the sole member to dissent from the Fed's decision to retain the "extended period" pledge.

Hoenig fears keeping rates too low for too long could lead to excessive risk-taking by investors and feed new speculative bubbles in the prices of stocks, bonds and commodities.

He's also expressed concern that low rates could eventually unleash inflation. And Hoenig said he worries that keeping the "extended period" pledge will limit the Fed's stated "flexibility" to start modestly bumping up rates.

Given the risks to the recovery, the Fed left a key bank lending rate at between zero and 0.25 percent. The rate has remained at that level since December 2008.

That means rates on certain credit cards, home equity loans, some adjustable-rate mortgages and other consumer loans will remain low. Commercial banks' prime lending rate would stay at about 3.25 percent, the lowest point in decades.

Low rates serve borrowers who qualify for loans and are willing to take on more debt. But they hurt savers. Low rates are especially hard on people living on fixed incomes who are earning scant returns on their savings.

Still, if the rates spur Americans to spend more, they would help invigorate the economy. That's why the Fed maintained its pledge, in place for more than a year, to keep rates at record lows for an "extended period."

Because the fragile recovery is more vulnerable to shocks, from home and overseas, economists increasingly say the Fed probably won't start boosting rates until next year -- or possibly into 2012. That's a change from a few months ago, when economists thought the Fed would begin raising rates at the end of this year.

"Increased market volatility and uncertainty on the economic outlook may cause the Fed to delay raising rates until well into next year," said Kurt Karl, chief U.S. economist at Swiss Re.

The Fed has leeway to hold rates at record lows because inflation is essentially nonexistent. In fact, the Fed noted that the price of energy and other commodities have dropped in recent months, and that underlying inflation has "trended lower." That seems to suggest that Fed policymakers are a bit more concerned about the remote prospect of deflation, versus inflation.

T.J. Marta, a market strategist at Marta on the Markets, called the Fed's policy statement "more dovish" and reinforces the belief that the central bank won't need to start boosting rates any time soon to fend off inflationary pressures.

After suffering the worst recession since the 1930s, the economy has been growing again for nearly a year. Manufacturing activity is picking up. Businesses are spending more. And Bernanke has expressed confidence that the nation won't fall back into a "double dip" recession.

Still, the strength of the recovery could be affected by the European debt crisis, an edgy Wall Street, cautious consumers, a fragile housing market and high unemployment.

If the U.S. recovery were to flash signs of a relapse, the Fed would likely take other steps to get it back on course. The Fed has left the door open to resuming purchases of mortgage securities, a move that would drive down mortgage rates and bolster the housing market. It ended a $1.25 trillion mortgage-buying program in March.

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AP Business Writer Stevenson Jacobs in New York contributed to this report.