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Fed holds on rates, upbeat on economy

The Federal Reserve leaves interest rates alone for the second time this year, noting that the prospects for the U.S. economy are improving.

The Federal Reserve on Tuesday decided to leave interest rates unchanged for the second time this year, noting that the prospects for the U.S. economy are improving.

The federal funds rate will stay at 1.75 percent, its lowest level since 1961, and the discount rate will remain at 1.25 percent. The funds rate is the interest that banks can charge each other for overnight loans; the discount rate is what the Fed charges banks to borrow.

In explaining its decision, the Fed said recent data show hopeful signs of improvement in an economy that has been stuck in a recession.

"The information that has become available since the last meeting of the Committee indicates that the economy, bolstered by a marked swing in inventory investment, is expanding at a significant pace," the Fed said in a statement.

But the Fed did caution investors, saying U.S. business still has to endure some sluggish times before reaching solid ground.

"Nonetheless, the degree of the strengthening in final demand over coming quarters, an essential element in sustained economic expansion, is still uncertain," the Fed said.

The Fed also shifted its outlook to neutral, saying the negative factors affecting the economy are balanced by the positive signs that point toward growth. This means that based on the information available, the Fed is more likely to hold on rates in the future.

In its Jan. 30 statement, Fed policy-makers said indicators pointed toward a weakening economy.

The change in its "bias" means the Fed is opening the door to start raising interest rates again if it believes the economy is overheating, raising the specter of inflation.

The Fed took an ax to interest rates last year, enacting a series of 11 cuts including three that were unscheduled.

Recent economic data have indicated that the U.S. economy is in a recession, which is usually defined as two consecutive quarters of negative economic growth.

The Gross Domestic Product (GDP), the value of all U.S. goods and services, grew 1.9 percent in the fourth quarter of 2000, 1.3 percent in the first quarter of 2001 and 0.3 percent in the second quarter, and fell 1.3 percent in the third quarter.

But recent signs indicate that the United States might be in the early stages of fighting off its economic flu. Preliminary data of fourth-quarter GDP released Feb. 28 show the economy grew 1.4 percent--something that may have influenced the Fed's decision. The Commerce Department will release the final version of fourth-quarter GDP on March 28.

The Fed took a different stance on interest rates in 1999 and 2000, when the economy was booming. It raised the funds rate six times for a total increase of 1.75 percentage points to a high of 6.5 percent in May and increased the discount rate five times, to 6 percent, an increase of 1.5 percentage points.

The Fed's primary mission is to counter inflation, and its main weapon is interest rates. When it believes the economy is growing at a rate that could ignite inflation, it often raises rates, which increases the cost of borrowing money and can pinch corporate financial activity.

But the Fed lowers rates when the economy seems headed for trouble. Decreasing interest rates makes it less costly for businesses to finance expansion plans and increases the incentive to borrow money, which can spark economic growth. Lower rates can result in more stable stock prices as well, because interest-paying investments become less attractive.

The Fed's policy-making committee meets again May 7, 2002.

News.com's Larry Dignan contributed to this report.