Fed holds rates steady, shows more worry on prices

WASHINGTON (Reuters) - The U.S. Federal Reserve held interest rates steady on Wednesday and signaled it was in no hurry to raise them, even as it voiced greater concern about inflation.

The decision by the U.S. central bank left the benchmark overnight fed funds rate at 2 percent and effectively ended an aggressive rate-cutting campaign that the Fed launched in September to put a floor under an economy hit hard by a housing downturn and credit crisis.

"Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased," the Fed said.

The statement marked a small step toward a tougher anti-inflation stance from a central bank that until recently had been intently focused on the economy's weakness.

"While the (Fed) sees greater upside risk to inflation than it has previously, it stopped far short of signaling a timetable or even a commitment for a rate hike," Citigroup economist Robert DiClemente said in a note to clients.

"We see policy settling into a watchful, waiting mode, perhaps considerably longer than markets expect," he said.

U.S. stocks finished the session higher and prices for U.S. government bonds ended flat as traders scaled back expectations for a rate hike at the Fed's next meeting in August. Interest-rate futures put chances of an August increase at just over 30 percent, down from about 50 percent on Tuesday.

At the same time, the dollar hit a two-week low against the euro, undercut by the expectation that the gap between U.S. and euro-zone interest rates is set to widen. Earlier on Wednesday, a comment from European Central Bank President Jean-Claude Trichet had cemented expectations of an ECB rate hike in July.

A Reuters poll of 16 top bond dealers found that most do not expect the Fed to start raising rates until the middle of next year.

WORRIES ON BOTH SIDES

Policy-makers at the U.S. central bank are at a difficult juncture. A deepening housing decline looks like it will be a drag on economic growth for months to come, even as higher oil and commodity prices threaten to ignite broader inflation.

The Fed's decision, in a 9-1 vote by its rate-setting committee, marked the first time it had held rates steady at a policy session since embarking on a series of rate reductions in September. Dallas Fed President Richard Fisher dissented, saying he preferred to raise rates.

Despite stronger inflation language, the Fed voiced lingering concerns about obstacles to growth over the next several quarters posed by tight credit, the housing slump and rising energy prices.

Still, it said "overall economic activity continues to expand." After its last meeting April 30, it described economic activity as "weak."

Senior Fed officials in recent weeks have said that risks of a serious recession had receded after a period of turmoil marked by surging mortgage delinquencies and the near bankruptcy of investment bank Bear Stearns, and they have begun to turn their sights on the need to contain inflation.

With oil prices that hit record highs in early June just shy of $140 a barrel, top Fed officials have said they would be particularly vigilant to ensure expectations of higher inflation do not build in a way that could set off a harmful upward spiral of rising prices and wages.

In its statement on Wednesday, the Fed described inflation expectations as "elevated." In April, it had simply noted that they had risen.

At the same time, however, the economy has yet to show any clear signs of vigor.

The government said on Wednesday that new home sales fell 2.5 percent in May, and reports released earlier in the week showed another record annual drop in house prices in April, while consumer confidence slid this month to a 16-year low.

(Additional reporting by David Lawder; Editing by Tim Ahmann and Jan Paschal)