Fed Holds Rate at 2%

Updated from 2:17 p.m. EDT

The Federal Reserve held its key interest-rate target at 2% Tuesday, indicating that the central bank would rather continue its plan to fight inflation than provide much-needed liquidity to damaged credit markets.

The Federal Open Market Committee noted that strains in the financial markets have increased significantly and that labor markets have continued to weaken. Tight credit conditions, continued housing woes and some slowing in export growth should weigh on growth over the next few quarters. However, the FOMC reiterated its position that the economy will stay afloat with the initiatives already put in place.

"Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth," the FOMC said in a statement.

The FOMC added that inflation has been high, spurred by energy prices, and that it expects inflation to "moderate later this year and next year." However, the central bank noted that the outlook "remains highly uncertain."

The market was caught off guard by the Fed's decision to not cut rates, as the major averages fell to their lows of the session before spiking higher. It had been widely expected that the FOMC would cut the fed funds target rate to 1.75%, as fed funds futures had priced in a 100% chance of a 25-basis-point cut early Tuesday.

The Fed's decision to not lower rates comes during a time of turmoil for financial markets, including the failure of Lehman Brothers ( LEH), which filed for Chapter 11 bankruptcy protection Monday, the surprise buyout of Merrill Lynch ( MER) by Bank of America ( BAC) and the potential collapse of AIG ( AIG).

"They're trying to send a message, rightly or wrongly, that they're here to protect against systemic risk. They're not here to ensure survival," says Doug Roberts, chief investment strategist for Channel Capital Research. "They want to make a clear differentiation between protection against systemic risk and corporate risk. The story isn't over yet."

Ian Shepherdson, chief economist with High Frequency Economics, says that the Fed should win a gold medal for understatement when it comes to acknowledging the recent events that have unfolded on Wall Street by failing to speak about maintaining market confidence or financial stability.

"In our view this statement is either very brave or very reckless," Shepherdson says via email. "Not to acknowledge the catastrophes of the next few days runs the very serious risk that the Fed will be seen as Nero, fiddling while Wall Street burns. The gamble is that the chaos will subside in due course, AIG will survive and Fed inaction will be seen to be the right decision."

Between September and April, the Fed lowered its target by 325 basis points to ease the cost of lending and promote economic growth; it has held rates steady at 2% since then. The rate target directly affects short-term loans between banks, but it has a trickle-down effect on other consumer loans and thus affects prices and demand in the struggling housing market.

Earlier Tuesday, the Fed said it had injected a large amount of liquidity into the financial market. The Federal Reserve Bank of New York delivered $50 billion to money markets via overnight repurchasing agreements, or repos, and that it "stands ready to arrange further operations later in the day, as needed."

In addition, the Fed also conducted its usual Tuesday morning $20 billion, 28-day single-tranche repo, bringing the total amount of repos to $70 million.

Earlier, the European Central Bank injected 70 billion euros, or nearly $100 billion, in one-day funds into European money markets, more than doubling the 30-billion-euro injection the ECB announced Monday. Additionally, the Bank of England, the Bank of Japan and the Swiss National Bank all delivered extra funds to markets.

The U.S. equities market spent most of the morning mired in red. "This is smacking of desperation, which is why the markets aren't reacting very well," says Paul Nolte, director of investments with Hinsdale Associates. "When you're levered up, it takes a hell of a lot of money to get unlevered and make it worth anything. Now we're not just adding our liquidity, we're asking banks from around the world to add their liquidity."

These drastic capital-infusion moves by the world's central banks follow the worst day for U.S. equities in years. On Monday, the Dow Jones Industrial Average dropped a staggering 504.48 points, or 4.4%, to 10917.51, its worst single-day point drop since the market reopened six days after the terrorist attacks of Sept. 11, 2001.