(Corrects increase in discount rate to 0.75 percent in third paragraph)

NEW YORK/SAN JUAN, Puerto Rico - 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.

New York Fed President 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.

After the Fed raised its discount rate by a quarter percentage point to 0.75 percent late Thursday, three other Federal Reserve officials had 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 prices slipped immediately after the Fed move. Stocks fell further on Friday on concerns the change represented the start of a retreat by the Fed from its easy money policy.

Dudley, speaking at a conference in San Juan, Puerto Rico, described Thursday's move 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 remains pegged near zero, an all-time low.

Though Fed Chairman Ben Bernanke had flagged the discount rate change last week, markets had not expected the Fed to act so soon.

The timing of the move on Thursday, after the U.S. stock market had closed and well ahead of 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.

Dudley said the economy has started to recover but noted that growth will remain modest. He also said access to credit is limited and the unemployment rate unacceptably high, all of which should keep price pressure under control.

A government report on Friday showed consumer prices rose by less than expected in January, while prices excluding food and energy fell for the first time since 1982.

That helped U.S. government bond prices reverse some of their losses from Thursday after the Fed hiked the discount rate.

Other Fed officials also stressed the increase in the discount rate did not represent a speeding up of the central bank's plans for raising its main interest rate.

On Thursday, St. Louis Federal Reserve Bank President James Bullard said investors belief in 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.

Dennis Lockhart, president of the Atlanta Fed, said in a speech that monetary policy, as evidenced by the fed funds rate target, remains accommodative, adding this stance is necessary to support a recovery that is in an early stage and, in my view, still fragile.


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.

Still, stock markets were on the defensive, as the Fed's action follows 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.

David Kotok, chairman of Cumberland Advisors in Vineland, New Jersey, said he still thinks benchmark rates will remain at record lows throughout 2010, but he said the Fed has 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 it said it would assess over time whether it needed to further widen the spread between the two rates.

Some other central banks around the world have begun to tighten policy. In the United States, however, the Fed has said record low interest rates are still warranted with the unemployment rate near 10 percent.

I don't think the Fed dares (to) increase the fed funds or policy rate in the face of unemployment at double-digit type of levels, Bill Gross, the manager of Pimco, the world's biggest bond fund, told Reuters after the Fed announcement.

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)