US RATE FUTURES-Dealers take Fed at its word on low rates

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By Ros Krasny

CHICAGO Aug 12 (Reuters) - Interest rate dealers seemed prepared to take the Federal Reserve at its word on Wednesday that U.S. interest rates will stay very low for an "extended period" following a two-day Fed policy meeting.

Bets on interest rate hikes in the first half of 2010 were pared sharply after the Fed reiterated its policy stance and said that resource slack would keep inflation "subdued for some time."

The implied prospects for the Fed's first rate increase to come in January fell to 36 percent from 54 percent shortly before the end of the Federal Open Market Committee's meeting.

The Fed has kept its benchmark lending rate in a rock-bottom range of zero to 0.25 percent since December in an attempt to support the U.S. economy.

"They will persist with this policy well into next year," said Kurt Karl, chief economist at Swiss Re in New York. "With high unemployment and low capacity utilization, inflation will not be a problem."

The fed funds rate for mid-2010 implied by futures prices fell to less than 1 percent after peaking above 1.25 percent on Friday, when the Labor Department showed job losses in July were less than expected.

Wednesday's FOMC policy statement gave a slightly more upbeat, but guarded, assessment of the U.S. economy, saying for the first time that activity is "leveling out" but was likely to remain weak "for a time."

"The Fed is threading a needle," said Doug Roberts, chief investment officer at Channel Capital Research in Shrewsbury, New Jersey. "It's too soon to declare the (problem is) over, but Bernanke had to do something to show he's not going to get behind the inflation curve."

The Fed made a baby step in that direction on Wednesday by saying it would not increase its purchases of long-term Treasury debt, even though it extended the $300 billion program by a month, through October.

"It's an important split -- they won't expand the program, but recognize that the economy still has vulnerabilities," said David Watt, senior currency strategist at RBC Capital Markets in Toronto.

Roberts forecast that it would be "a long time" before the Fed raises rates given the fragile nature of the recovery.

For Fed Chairman Ben Bernanke, a mild increase in inflation would be preferable to risking a 1930s-style policy error of tightening policy too soon, he said. (Editing by Leslie Adler)