Fed promises to keep rates low at least 2 yrs

By Pedro da Costa and Mark Felsenthal

WASHINGTON (Reuters) - The U.S. Federal Reserve, in an unprecedented move, said on Tuesday it will keep interest rates near zero for at least two more years and is considering further action, bolstering battered stock markets.

The Fed's policysetting Federal Open Market Committee, in a 7-3 vote, overcame internal discord in the first triple dissent against a policy decision since 1992.

Investors were still unsure whether the Fed's even stronger promise to maintain rates at rock-bottom lows until mid-2013 would be enough to revive a flagging economic recovery.

But the decision sparked a rally in equities that pushed the Dow Jones industrial average up more than 400 points. Short-term Treasury yields fell to all-time lows. The gains came after a rout that stemmed from Standard & Poor's historic downgrade of U.S. credit quality last Friday.

Analysts said there was still plenty of unease about the economy, which was reflected in a heightened level of concern from the U.S. central bank.

"The statement was extremely negative in its outlook on the economy," said Omer Esiner, chief market analysts at Commonwealth Foreign Exchange in Washington.

"By pegging the extraordinarily low interest rates to a date in the distant future, the Fed has essentially said that they see the current level of weakness lasting far longer than previously expected.

INFLATION NO WORRY

The Fed said U.S. economic growth was proving considerably weaker than expected and said inflation will remain contained for the foreseeable future.

The dissenters were Richard Fisher of the Dallas Fed, Narayana Kocherlakota of Minneapolis and Charles Plosser of Philadelphia, who wanted to avoid any specific time reference on the low-rates pledge.

"The committee currently anticipates that economic conditions -- including low rates of resource utilization and a subdued outlook for inflation over the medium run -- are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013," the Fed said.

It also reiterated its policy of reinvesting the proceeds from bonds maturing in its portfolio, though it did not state a specific time frame for such actions.

One analyst said the Fed's language left open the possibility of a third round of bond-buying, referred to as quantitative easing.

"They certainly didn't close the door on QE3," said Michael Yoshikami, chief investment strategist at YCM Net Advisors in Walnut Creek, California.

SOME DOUBTERS STILL

The Fed action was likely inadequate to calm markets, said Cary Leahey, Decision Economics Inc. Senior Economist in New York.

"The market needs a sense that the Fed is willing to do more today, rather than merely say that they're not going to tighten in mid-2012 versus 2013," Leahey added.

The Fed's decision comes amid financial market turmoil as worries about the global economy escalate after an embarrassing downgrade of U.S. debt. In addition, fears remain that European efforts to put a safety net under heavily indebted Italy and Spain may not suffice to avert wider credit market disruptions.

In an attempt to tamp down market volatility, finance ministers and central bankers of the Group of Seven major world economies held a global telephone conference on Sunday and then issued a statement saying they were ready to act to ensure stability.

Officials had been pinning hopes for an acceleration of U.S. growth in the second half of the year on a healing of supply chain disruptions from Japan's natural disasters, a calming of Europe's debt problems as governments committed to more sustainable fiscal paths, and steady gains in business and consumer confidence in the United States.

But those expectations, along with the Fed's forecast for a growth rate of between 2.7 percent and 2.9 percent in 2011, have appeared increasingly over-optimistic in recent weeks.

While there were modestly encouraging signs in hard-hit labor markets in July, the unemployment rate remained lofty at 9.1 percent. Other economic reports have pointed to weak manufacturing and sluggish consumer spending.

A Reuters poll showed analysts now see a one in four chance the U.S. economy will slip back into recession. Two weeks ago, economists saw the chances of another recession as one in five.

Economists also cut their forecasts for third-quarter growth to an annualized 2.3 percent from 3.1 percent in the July poll.