By Steven C. Johnson and Kristina Cooke
NEW YORK/SAN JUAN, Puerto Rico (Reuters) - The Federal Reserve on Friday poured more cold water on speculation that a surprise hike to its emergency lending rate signaled a change in monetary policy, saying borrowing costs in the economy would remain low.
The president of the New York Fed, William Dudley, said the central bank's pledge to keep benchmark borrowing costs low for an extended period of time "is still very much in place."
The Fed raised its discount rate by a quarter percentage point to 0.75 percent late Thursday, after the close of U.S. financial markets. Three Fed officials on Thursday evening had also stressed that the move did not represent a tightening of U.S. monetary policy.
The U.S. dollar jumped, U.S. Treasury bond prices fell and stock futures slipped immediately after the discount rate hike, as investors bet the change represented the start of the Fed's retreat from its easy money policy. Stocks initially fell further on Friday, but reversed course as investors saw the rate hike as a sign of strength in the economy.
Dudley, speaking at a conference in San Juan, Puerto Rico, described Thursday's decision to lift the discount rate -- at which banks can borrow from the Fed -- as a small technical change that carried no broader signals about U.S. monetary policy.
The benchmark federal funds rate for overnight interbank borrowing, the Fed's chief monetary policy tool, remains pegged near zero percent, an all-time low.
Though Fed Chairman Ben Bernanke last week had said that the U.S. central bank could soon raise the discount rate, markets had not expected the Fed to act so quickly.
The timing of the move on Thursday, after the U.S. stock market had closed and well ahead of the central bank's March 16 policy meeting, prompted investors to price in a greater chance of a rise in the federal funds rate late this year.
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Thursday's move was the first increase in any of the Fed's lending rates since the financial crisis blew up in 2007 and the first rate change since December 2008.
Stock markets were on the defensive, as the Fed's action followed China's moves to curb lending to slow the world's third largest economy. That served as a reminder that the period of cheap cash that led to last year's stock market rally may be slowly drawing to an end.
"This is a significant and likely symbolic move that will impact on market sentiment," Robert Rennie, a strategist at Westpac in Sydney said in The Dealing Room, a Reuters Messaging chat room.
"The emergency easing cycle began with discount rate cuts -- it was all about easing liquidity to banks. So the move to raise the discount rate means the long journey toward normalization has begun."
The Fed's view of the economy has brightened in recent months. Businesses are slashing fewer jobs and buying more equipment and software while consumer spending has picked up moderately.
But while Dudley acknowledged that recovery was under way, he said unemployment remained "unacceptably high" and credit hard to come by. That, he said, will keep growth modest and inflation under control.
The government on Friday reported that U.S. consumer prices excluding food and energy fell last month for the first time since 1982, helping government bond prices reverse some of the losses booked after Thursday's discount rate hike.
On Thursday, St. Louis Federal Reserve Bank President James Bullard said investors' belief in the high probability of a rise in the Fed's benchmark rate this year was "overblown" and that the discount rate rise should not be seen as a policy signal.
Also on Thursday Dennis Lockhart, president of the Atlanta Fed, said in a speech that "monetary policy, as evidenced by the fed funds rate target, remains accommodative," which he said "is necessary to support a recovery that is in an early stage and, in my view, still fragile."
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Some other central banks around the world have begun to tighten policy.
But Bill Gross, co-chief investment officer of Pacific Investment Management Co., the world's biggest bond firm, said he doubts the Fed is in a rush to follow suit, even after this week's discount rate hike.
"I don't think this changes anything. The Fed is still on hold in our opinion," he said. "I don't think the Fed dares increase the fed funds or policy rate in the face of unemployment at double-digit type of levels."
Gross, who oversees more than $1 trillion in assets, told Reuters his asset-allocation mix will remain the same. He said Pimco has been shifting some of its assets from Treasuries to German bunds "and other perhaps more solvent or potentially solvent sovereign credits."
David Kotok, chairman of Cumberland Advisors in Vineland, New Jersey, said that despite the Fed's efforts to downplay its move, it had injected a sense of uncertainty into the market.
"If you do surprise the markets, then why go to great lengths to explain that you are not tightening and that the policy is the same as it was before the announcement?" he said. "If it was the same as before the announcement, why make the announcement and why make the changes?"
Before the financial crisis, the discount rate was typically a full percentage point above the federal funds rate. Thursday's decision begins to move it back nearer to its traditional premium and the Fed said it would assess whether it needed to further widen the spread between the two rates.
In an interview with Reuters Insider TV on Friday, former Fed governor Lyle Gramley said the hike in the discount rate was "part of the process of normalization" and predicted one or two more such hikes before it raises benchmark rates, likely in early 2011.
Other changes announced on Thursday included shortening the typical maximum maturity for primary credit loans to overnight from 28 days, effective March 18, and raising the minimum bid rate for the Fed's Term Auction Facility, another scheme put in place to foster market liquidity.
(Additional reporting by Emily Kaiser in Washington, D.C. and Jennifer Ablan in New York)
