As widely expected, the US Federal Reserve has kept the target federal fund rate at 5.25 per cent at its policy meeting yesterday. Stock and bond prices rallied after the Fed changed the language of its policy statement, which analysts and traders have interpreted as a more neutral policy stand. The changes have also raised hopes that the Fed's next policy action would be a rate cut.

The Fed, in its previous statements, has been maintaining that further rate hikes would be dependent on economic data. In yesterday's statement, the phrase 'any additional firming' has been dropped. It says, 'future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information'. Most economists believe that this change in language is indicative of a change in policy bias from further tightening towards a neutral stand.

The latest policy statement is less optimistic on US economic growth. While the recent economic indicators have been mixed, the housing sector adjustment is still ongoing, the Fed said. Till recently the Fed was hopeful that the housing sector would stabilise shortly and may even recover. Despite the positive data on February new housing starts, the US housing sector is still quite a long way from recovering as prices still remain subdued. Mortgage lenders would continue to face pressure, unless housing prices stabilise or interest rates come down.

The Fed has not yet given up on a soft landing for the US economy. 'Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters', the statement said.

Other parts of the statement confirm that the Fed is still very concerned over inflation, which would mean that financial markets may be hoping too much too soon. The statement has maintained that recent inflation data has been 'somewhat elevated'. Like in previous statements, the Fed says 'high level of resource utilisation' has the potential to sustain inflation pressures. In view of these factors, the Fed's 'predominant policy concern' remains the risk that inflation may not moderate as expected.

Though it is accepted that factors fuelling domestic inflation in the US have become more subdued, the risks of another up trend in prices remain. Oil prices have been range bound in recent months, but may rise if heating demand increases as predicted because of colder weather conditions this year. Replenishment of oil inventories which are nearing 10-year low and fresh additions to US strategic oil reserves would also increase demand this year.

The US job market is yet to show any clear signs of a down trend. Steady wages should keep consumer demand from falling, unless there is a substantial rise in retail fuel prices. Though US corporate demand has shown some signs of slack in recent months, it would revive easily if consumer demand remains firm.

These factors make it entirely possible that US inflation does not decline as expected. If that happens, the Fed would not contemplate a rate cut this year as hoped by many.