Fed raises US rates, softens inflation rhetoric

WASHINGTON, June 30 (Reuters) The Federal Reserve raised U.S. interest rates a 17th straight time on Thursday, but fired up financial markets by toning down its warnings about the possible need for further increases.

As widely expected, the central bank's policy-setting Federal Open Market Committee voted unanimously to lift the benchmark federal funds rate target a quarter-percentage point to 5.25 percent, its highest since March 2001.

In a statement announcing its action, the Fed said moderating growth should help ease price pressures, even though it held out the possibility it could extend a two-year credit tightening campaign.

''Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the committee judges that some inflation risks remain,'' it said.

''The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information,'' it added.

U.S. stock and government bond prices rose and the dollar tumbled as financial markets saw the statement as suggesting chances of another boost to borrowing costs in August as lower than traders had wagered before the meeting.

By late afternoon, the blue chip Dow Jones industrial average <.dji> surged 217.24 points, or 1.98 percent, the biggest one day percentage gain in over a year.

The probability of an August rate hike as reflected by trading in interest-rate futures markets fell to about 60 percent after the announcement from above 80 percent before.

''The language strikes me as being a step back from the relentless hawkish talk the Fed has been engaged in on inflation,'' said Wan-Chong Kung, a portfolio manager at First American Funds in Minneapolis.

The fed funds rate governs overnight lending between banks, but it can influence a wide range of borrowing costs.

In the wake of the Fed's action, many banks raised the prime rate charged for loans to their best customers -- a baseline for credit cards and home loans -- to 8.25 percent.

KEEPING OPTIONS OPEN The increase in the fed funds rate was the latest in a string of quarter-point moves dating to June 2004, when the central bank began moving credit costs up from a 1958-matching low of 1 percent.

Economists had expected the Fed to extend the series after a number of troubling core inflation readings and tough remarks from officials. But analysts have been divided -- and remained divided -- over how much further the Fed might go.

''They are definitely not closing the door on anything,'' said Kurt Karl, chief U.S. economist at Swiss Re in New York. ''The economy is in solid shape by the inflation risks are still bigger than the growth risks.'' Some think the higher price of credit the central bank has already put in place will slow economic growth enough to wring inflation pressures out of the system, and the Fed did nod to the restraining influence of its prior actions.

Others have argued overnight rates might need to be pushed up as high as 6 percent to ensure inflation does not gain a foothold.

The core U.S. consumer price index, which strips out volatile food and energy prices, has risen a surprisingly steep 0.3 percent in each of the past three months, an acceleration Bernanke had called ''unwelcome.'' Lofty energy prices and a historically low unemployment rate, which hit a 5-year low of 4.6 percent last month, have exacerbated the central bank's inflation concerns.

U.S. Commerce Secretary Carlos Gutierrez told Reuters on Thursday the Fed had done a good job at keeping core inflation tamped down given the sharp acceleration in energy prices.

''We're not going to second-guess the Federal Reserve,'' he said.

''They've got the tools. They've got the data, the people and the skills.'' At the same time core inflation has picked up, employment growth has slowed and the long-hot U.S. housing market has started to come off the boil. While the economy shot ahead at a 5.6 percent annual rate in the first quarter, economists think it has already throttled back to a more comfortable pace.

REUTERS PV GC1522