Fed seeks to calm markets after discount rate rise

Traders work on the floor of the New York Stock Exchange, February 18, 2010.

NEW YORK/SAN JUAN, Puerto Rico (Reuters) - The Federal Reserve on Friday poured more cold water on speculation that a surprise rise in its emergency lending rate signaled it was moving faster to rein in its easy money policies.

The president of the New York Fed, William Dudley, said the central bank's pledge to keep benchmark borrowing costs low for an extended period of time "is still very much in place."

The Fed raised its discount rate by a quarter percentage point to 0.75 percent late Thursday, the first change to its interest rates since December 2008.

Three Fed officials on Thursday evening also stressed the move did not represent a tightening of monetary policy.

The dollar jumped, Treasury bond prices fell and stock futures slipped immediately after the discount rate hike as investors bet the change could signal a speeding up of the Fed's retreat from emergency measures to support the economy.

Stocks initially fell further on Friday but closed marginally higher as investors saw the rate hike as a sign of strength in the economy.

Government data showing consumer prices excluding food and energy fell for the first time in 28 years helped ease concern on Wall Street, as it suggested the Fed need not rush to raise broader borrowing costs.

Dudley, speaking at a conference in San Juan, Puerto Rico, described Thursday's decision to lift the rate at which banks can borrow from the Fed as a small technical change that carried no broader signals about U.S. monetary policy.

The benchmark federal funds rate for overnight interbank borrowing, the Fed's chief monetary policy tool, remains pegged near zero percent, an all-time low.

Though Fed Chairman Ben Bernanke last week had said that the U.S. central bank could soon raise the discount rate, markets had not expected the Fed to act so quickly.

The timing of the move on Thursday, after the U.S. stock market had closed and well ahead of the central bank's March 16 policy meeting, prompted investors to price in a greater chance of a rise in the federal funds rate late this year.

Thursday's move was the first increase in any of the Fed's lending rates since the financial crisis blew up in 2007 and the first rate change since December 2008.

It followed China's moves to curb lending to slow the world's third largest economy. That served as a reminder that the period of cheap cash that led to last year's stock market rally may be slowly drawing to an end.

Still, a Reuters poll on Friday showed the large financial firms that do business directly with the Fed do not think the discount rate move reflects a broader shift in monetary policy. Most think a benchmark rate hike won't come before the second half of the year.

Fed funds futures contracts have priced in a quarter point hike by November, with chances of another quarter point hike in December on the rise.

"Investors know the Fed is marching toward a hike," said Quincy Krosby, market strategist at Prudential Financial in Newark, New Jersey. "The question is, 'Is it a long or a short march?'"

U.S. RECOVERING, PRICE PRESSURES TAME

The Fed's view of economy has brightened in recent months. Businesses are slashing fewer jobs and buying more equipment and software while consumer spending has picked up moderately.

But while Dudley acknowledged that recovery was under way, he said unemployment remained "unacceptably high" and credit hard to come by. That, he said, will keep growth modest and inflation under control.

The government reported Friday that U.S. consumer prices excluding food and energy fell last month for the first time since 1982, helping government bond prices reverse some of the losses booked after Thursday's discount rate hike.

St. Louis Federal Reserve Bank President James Bullard said on Thursday that talk of a benchmark rate hike was "overblown," while Atlanta Fed President Dennis Lockhart said in a speech that loose monetary policy is "necessary to support a recovery that is in an early stage and, in my view, still fragile."

Some other central banks have begun to tighten policy. But Bill Gross, co-chief investment officer of Pacific Investment Management Co., the world's biggest bond firm, said he doubts the Fed is in a rush to follow suit.

"I don't think this changes anything. The Fed is still on hold in our opinion," he said. "I don't think the Fed dares increase the fed funds or policy rate in the face of unemployment at double-digit type of levels.

Before the financial crisis, the discount rate was typically a full percentage point above the federal funds rate. Thursday's decision begins to move it back nearer to its traditional premium and the Fed said it would assess whether it needed to further widen the spread between the two rates.

In an interview with Reuters Insider TV on Friday, former Fed governor Lyle Gramley said the hike in the discount rate was "part of the process of normalization" and predicted one or two more such hikes before it raises benchmark rates, likely in early 2011.

But others said the Fed had introduced uncertainty into the market, which would continue to impact investor risk appetite and prices.

"The Fed is saying it's normalization," said Boris Schlossberg, director of research at GFT Forex in New York, "but if you go from dovish to normal, that's tightening."

(Additional reporting by Emily Kaiser in Washington, D.C. and Jennifer Ablan, Emily Flitter, Rodrigo Campos and Gertrude Chavez-Dreyfuss in New York)