UPDATE 1-Morgan Stanley sees Fed on hold until early 2011

Mon May 10, 2010 10:56am EDT

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(Recasts, adds details from research note)

NEW YORK May 10 (Reuters) - Morgan Stanley said on Monday it expects the Federal Reserve to stick to its near-zero interest rate policy until early 2011 in the wake of the sovereign debt crisis in Europe and its fallout on global growth.

The U.S. investment bank had previously forecast a September increase in short-term interest rates.

Once the Fed begins to raise rates, the central bank's target rate on federal funds, or overnight loans of excessive reserves between U.S. banks, will climb to 2.50 percent by the end of next year, Morgan Stanley said.

The bank also downgraded its outlook on the 10-year U.S. Treasury yield. It sees the benchmark yield rising to 4.50 percent by year-end, 1 percentage point lower than its previous forecast.

"The European sovereign credit crisis, its threat of contagion beyond Europe, and its effect on inflation expectations is the key reason for these significant changes," Morgan Stanley said in research note.

Morgan Stanley had been one of the few top Wall Street firms to have forecast a dramatic spike in U.S. yields in the second half of the year due to heavy federal borrowing and accelerating U.S. economic growth.

It said the threat of the European debt crisis slowing U.S. growth will be limited, for now, after euro zone nations and the International Monetary Fund unveiled a $1 trillion rescue package over the weekend in an effort to restore market confidence.

Fears of contagion from the debt woes of Greece and other weaker euro zone members have battered those nations' debt and global stock markets.

"We believe that the spillover to U.S. growth will be muted, as contagion will mainly affect European banks, credit availability in Europe, and European growth," Morgan Stanley economists Richard Berner and David Greenlaw wrote in the research report.

They upgraded their forecasts of real U.S. growth in 2010 to 3.5 percent from their earlier estimate of 3.2 percent. They also raised their 2011 GDP outlook to 3 percent from a previous forecast of 2.5 percent.

The Fed adopted a near-zero rate policy in December 2008 in a bid to combat a recession worsened by the global credit crisis. (Reporting by Richard Leong; Editing by Dan Grebler)

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