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WASHINGTON (Reuters) - The Federal Reserve on Wednesday inched closer to buying U.S. government bonds in a new front in its fight against the credit crisis and signaled unease over the risk of deflation with the economy weakening.
The U.S. central bank, battling the worst recession since World War Two, held its main interest rate in a range from zero to 0.25 percent and said it could stay unusually low for some time.
With no room to cut short-term rates, the Fed said it stood ready to buy long-term government debt if it felt it would help ease credit more broadly. Bond purchases could lower mortgage rates, helping to curb the housing downturn at the root of the global economy's ills.
Treasury debt investors were disappointed the Fed did not make a firm commitment to buy government bonds. U.S. government debt prices fell sharply, pushing the yield on the 30-year bond above 3.46 percent, the highest level since December 1.
"The committee ... is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets," the Fed said.
In December, the central bank said only that it was studying that option.
"The market may have been looking for more concrete confirmation that the Fed would buy Treasuries," said Gary Thayer, a senior economist at Wachovia Securities.
Stock prices added to gains and the Dow Jones industrial average closed up more than 2.4 percent. The dollar also rose against major currencies.
After a two-day meeting, the Fed's monetary policy panel backed the decision 8-1. Richmond Federal Reserve Bank President Jeffrey Lacker dissented, saying the Fed should immediately move to a program to purchase government bonds.
Lacker, who has frequently dissented in the past, has voiced concern about the Fed's interventions in private credit markets, suggesting his vote was more about tactics than how much money the central bank is pumping into the economy.
Since lowering overnight rates to virtually zero in December, the Fed has turned its focus to what Chairman Ben Bernanke has dubbed a "credit easing" approach of buying specific assets in the hope of restoring normal lending.
The central bank wants to prevent a year-long recession from turning into a prolonged period of falling prices that could devastate investment and cripple the economy.
"The committee continues to anticipate that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant," it said.
It added that it "sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term," -- a nod to growing concerns over the risk of deflation.
A Reuters poll of top Wall Street banks found 11 of 13 respondents expect the Fed to hold rates near zero until at least 2010 while 9 of 12 said the central bank would step in at some point to buy U.S. government bonds.
The Fed reiterated that, if needed, it would expand an existing program of buying large quantities of mortgage-related debt, and that it was about to launch another program to shore up auto, credit card and small-business lending.
The Fed's measures are part of broader U.S. efforts to combat the recession which has spread around the globe.
It has cut its key interest rate from 5.25 percent in 10 steps dating back to September 2007 and pumped billions of dollars into the economy to try to restore credit markets shattered by a bursting housing bubble and a wave of mortgage failures.
At the same time, President Barack Obama, who swept to victory in November in part because of the deepening economic gloom, is pushing for an $825 billion package of tax cuts and government spending. His administration is also wrestling with steps it can take to prop up the ailing banking system.
The outlook, however, remains almost uniformly grim.
A report on Friday is expected to show the economy contracted at a 5.4 percent annual rate in the final three months of last year, which would be the steepest falloff in activity for any quarter since 1982.
That was when former Fed Chairman Paul Volcker effectively brought the U.S. economy to a halt to kill high inflation.
Additional reporting by David Lawder and Emily Kaiser; editing by Gary Crosse