Fed holds rates steady

By Mark Felsenthal

WASHINGTON (Reuters) - The U.S. Federal Reserve held interest rates steady on Wednesday and said it remained concerned about inflation, but dropped its reference to the possibility of pushing rates higher, leaving its options open.

The decision by the central bank's Federal Open Market Committee to keep benchmark overnight rates at 5.25 percent, the level they hit in June after 17 straight quarter-percentage point increases, was widely expected.

However, in a shift that markets saw as evidence that the Fed is no longer leaning toward higher rates, officials said that "future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth."

That marked a change from January, when the Fed had said "the extent and timing of any additional firming that may be needed" would depend on the outlook.

"It was certainly less hawkish than before, although they still have the balance of risks tilted toward inflation rather than growth," said Jim O'Sullivan, an economist with UBS in Stamford, Connecticut. "It is not quite a neutral statement, but it is a big step in that direction."

Financial markets took the new language as opening the door to lower interest rates.

U.S. stock prices jumped higher and the blue chip Dow Jones industrial average closed up 159 points. At the same time, the dollar hit a two-year low against the euro, and bond prices rallied, with yields on short-dated maturities dropping below yields on longer-dated issues for the first time since August.

"The move in the yield curve suggests a fast-forwarding of rate cut possibilities," said Tony Crescenzi, chief bond market strategist with Miller, Tabak & Co. in New York.

U.S. short-term interest rate futures prices moved to show a 48 percent chance of a rate cut by the end of June, up from a 26 percent chance before the Fed's announcement.

UNEVEN GROWTH

In a statement outlining its decision, the Fed acknowledged recent signs of uneven economic growth and weakness in the housing sector, but expressed continued faith that the economy was fundamentally sound.

"Recent indicators have been mixed and the adjustment in the housing sector is ongoing," the Fed said. "Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters."

At the same time, the Fed made clear it was still worried about inflation. "The committee's predominant policy concern remains the risk that inflation will fail to moderate as expected," it said.

At its previous meeting in January, the central bank had said growth was looking "somewhat firmer." Since then, however, a jump in default rates for mortgages held by less-creditworthy borrowers has sparked worry that mainstream lenders might start also be affected and that it might become more difficult for households and businesses to borrow.

Beyond the subprime sector, there has been little to support the view that housing markets were stabilizing, as the Fed had believed.