As most economists expected, the Federal Open Market Committee decided to keep its target for the U.S. federal funds rate unchanged at 1.25%.

However, the Fed warned the economy was in danger of further weakness, indicating it stood ready to lower borrowing costs if needed.

The decision was widely expected, but the switch in bias toward weakness was not. In its last meeting, the Fed issued no bias, citing the extreme uncertainty created by the war in Iraq. The feeling is that the bias change makes it harder for the Fed not to cut later on, and some commentators suggest it signals deflation fears.

“Recent readings on production and employment, though mostly reflecting decisions made before the conclusion of hostilities, have proven disappointing. However, the ebbing of geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt and equity markets,” it said. “These developments, along with the accommodative stance of monetary policy and ongoing growth in productivity, should foster an improving economic climate over time.”

“Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future,” it also noted.

http://www.federalreserve.gov/boarddocs/press/monetary/2003/20030506/default.htm