US interest rates will remain low after Fed decision

US interest rates are set to remain low, the Federal Reserve Board has indicated.

Low inflation and spare resources in the economy mean that policy can continue to support growth "for a considerable period", according to a statement from the Fed's key policy-making committee yesterday evening.

The statement had been eagerly awaited by financial markets, who wondered if recent strength in the US economy would lead the Federal Open Market Committee - the key Fed policy-making group - to drop its indication that rates would remain low for some time. In the event, the key clause that "policy accommodation can be maintained for a considerable period" was retained in the statement .

It is taken as an indication that the Fed will not increase base rates for the current 45-year low of 1 per cent for some time.

However, the Fed made one change by dropping a warning contained in all recent statements that the danger of falling inflation - or deflation - outweighed that of inflationary pressures. The statement issued yesterday evening said that "the probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation."

Fears of a Japanese-style deflationary spiral are believed to have been a key factor leading the Fed to hold interest rates at such low levels. Analysts disagree on the likely timing of the first increase in the interest rate cycle, but with evidence growing of US recovery many believe it could be in the second quarter of 2004. The only recent sign of weakness was last Friday's job figures, which showed a surprisingly low rate of job creation in November.

On the US market, the Dow Jones Index had earlier broken the 10,000 level for the first time in 18 months. However, while prices rose in the immediate aftermath of the Fed statement, gains quickly fizzled out. Last night the Dow ended down 41.85 at 9,923.42.

The absence of any indication of an early interest rate rise is unlikely to provide much support to the US dollar, however. It was trading around $1.2260 in New York last night, not far off another record low against the euro, reached earlier in the day.

The euro reached a new high for the eighth day in a row, climbing to $1.2276, before edging back to just over $1.2237 before the Fed announcement, as investors with short positions in the currency took profits.

The dollar held just above a three-year low against the yen, matching Monday's nadir of 107.08 yen, before rising back to 107.25 yen, unchanged on the day.

Traders suspected dollar buying by Japanese institutions was the only thing preventing further dollar losses. Japan has thrown almost 18 trillion yen at the foreign exchange markets this year in a bid to prevent a strengthening currency from choking off the country's export-led recovery.

Investors remain focused on the large deficit on the current account of the US balance of payments and the need to finance this through continued large capital inflows. For the moment investors are focusing on this, rather than on signs of US economic recovery.

Attracting capital is made more difficult by low US interest rates. According to proprietary data from the Bank of New York, over the last three months, private non-US investors have sold over $5.6 billion, on a net-basis, in US fixed income assets. These data shows a better than 90 percent correlation with the drop in the dollar index to seven-year lows.

The US currency also hit its weakest level against sterling since 1992. Sterling was trading in New York last night above $1.74

The dollar's renewed decline raised questions as to how far the currency could fall before policymakers started to flex their muscles to address the decline.

The view that euro-zone policymakers' tolerance threshold had yet to be reached was underscored by a survey showing optimism among German investors and analysts rose to its highest in three-and-a-half-years in December, despite the euro's strength.

Germany's ZEW research institute said its expectations gauge for Germany rose more than expected to 73.4, the highest since June 2000.