US RATE FUTURES-Spike as Fed sets low funds target range

(Adds details, analyst comments, byline)

By Ros Krasny

CHICAGO, Dec 16 (Reuters) - Financial dealers on Tuesday bet that U.S. short-term interest rates will remain barely above zero for months after the Federal Reserve set a new, low range for its key lending rate and outlined other aggressive measures to support the economy.

"The message is that they're instituting quantitative easing on a fairly large scale," said Doug Roberts, chief investment strategist at Channel Capital Research in Shrewsbury, New Jersey.

After two days of deliberations. the FOMC set a target range for the fed funds rate of zero to 0.25 percent, down from the previous target rate of 1 percent.

Establishing a target range, rather than a target rate, was unexpected, and pushing that range all the way to zero also took the market by surprise.

But dealers said the Fed had opted to set a funds rate, or range, closer to where the effective rate has been trading for weeks. Cash fed funds traded at 0.0625 percent after the rate announcement, down from 0.125 percent.

Coming into the meeting, options traders had roughly an 11-percent bet on a zero interest rate, but the Wall Street consensus was that the FOMC would cut its target rate by 50 basis points, to 0.5 percent.

Futures prices jumped sharply as dealers positioned for the new, lower target range and the Fed's commitment to "exceptionally low levels of the federal funds rate for some time."

Futures FFG9 prices now imply a funds rate after the Jan 27-28 FOMC meeting of 0.17 percent, and by mid-2009 FFN9 of just 0.37 percent.

Fed officials have acknowledged that the bank started quantitative easing -- flooding the banking system with masses of money to promote lending -- a few months ago, and Tuesday's comments suggested the program is being ramped up.

The FOMC said its focus going forward would be on stimulating the U.S. economy "through open-market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level."

"Quantitative easing is likely to be targeted at boosting economic activity and lending, not directed at increasing inflation to avoid a prolonged period of deflation," said Kurt Karl, chief U.S. economist for Swiss Re.

Still, the Fed's statement said that the bank will use all available tools "to preserve price stability," which in the context of the ongoing U.S. economic recession suggests policy-makers are on high alert against damaging deflation.

(Editing by Chizu Nomiyama)