Fed holds policy steady, less worried on deflation

The Federal Reserve on Wednesday stuck to its huge program of buying government and mortgage debt and said it saw signs that the deep U.S. recession was easing.

The Fed -- the U.S. central bank -- kept interest rates at nearly zero and signaled less concern on deflation.

It also said inflation would remain subdued for some time and provided no hint on an imminent exit from bold policy easing, despite fears among investors the huge U.S. stimulus could stoke prices.

Concluding a two-day meeting, the Fed said it had decided to hold overnight interest rates in a zero to 0.25 percent range -- the level reached in December -- and repeated that they would likely stay unusually low for some time.

The Dow Jones industrial average stock index fell on the news as the Fed's caution that the economy would remain weak for a time dampened hopes for a faster rebound. Economists say this means rates will be on hold until well into 2010.

The Fed is highly likely to hold short rates at rock-bottom levels until the volume of economic 'slack' ... is substantially lessened, which means short rates are unlikely to rise any time soon, Michael Darda, chief economist at MKM Partners in Greenwich, Connecticut, wrote in a client note.

The dollar extended gains against the euro and the yen while prices on U.S. government debt fell in disappointment that the Fed did not increase its purchases of longer-dated Treasuries.

QUANTITATIVE EASING

With the benchmark interbank lending rate virtually at zero, the Fed has focused on driving down other borrowing costs by buying mortgage-related debt and U.S. government bonds.

In a statement, the Fed's policy-setting panel said it would hold to a previous pledge to buy $1.45 trillion in mortgage-related debt by year-end and $300 billion in longer-term U.S. government debt by autumn, a decision financial markets had largely expected.

Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing, the Fed said. Conditions in financial markets have generally improved in recent months.

The central bank dropped a phrase it had used in its last statement in April in which it warned inflation could run below desired levels for a time -- a suggestion officials were worried about a broad-based deflation.

While appearing more comfortable on deflation risks in their latest statement, policy-makers made clear inflation was not yet a concern.

The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the committee expects that inflation will remain subdued for some time, the Fed said.

HOLDING STEADY

With little change in the statement to chew over, economists focused on the Fed's continued caution.

Most importantly, despite the signs of some modest improvement in current conditions, the (Fed) continues to indicate that economic activity is likely to remain weak for a time, said Morgan Stanley economist David Greenlaw.

The Fed cut rates to near zero at the end of last year as part of a campaign to counter turmoil in financial markets and pull the economy out of a recession that began in late 2007.

Even with these overnight rates as low as they can go, the U.S. central bank has found ways to lower other borrowing costs. In March, it more than doubled its planned purchases of mortgage-related securities and announced a plan to buy Treasury debt to drive down benchmark yields.

At first, the initiative to buy government bonds pulled down longer-term rates, a boon to mortgage borrowers. But this month yields on longer-term Treasuries climbed sharply as investors began to fret that the massive U.S. budget deficit and generous Fed lending could sow the seeds of future inflation, although yields have since retreated.

Economic reports since the Fed's previous meeting on April 28-29 suggest the downturn in the economy, the deepest in decades, is starting to abate. In perhaps the most hopeful sign, U.S. job cuts moderated in May, although the unemployment rate hit a nearly 26-year high of 9.4 percent.

(Editing by James Dalgleish)