Aug. 8 (Bloomberg) -- The Federal Reserve kept the benchmark U.S. interest rate at 5.25 percent, suspending a two- year run of consecutive increases while leaving room for further moves should inflation accelerate.

The Federal Open Market Committee's statement after meeting in Washington today said inflation has been ``elevated'' and remains a risk, using wording identical to the last decision on June 29. The panel then added a new sentence predicting price pressures will abate because of past Fed moves and ``other factors restraining aggregate demand.''

The decision provoked the Fed's first public disagreement since Chairman Ben S. Bernanke took the central bank's helm in February. With policy makers counting on economic growth slowing enough to damp a pickup in prices, a wrong call may force them to clamp down harder in coming months and risk smothering the expansion.

``They have time to look at the data,'' Robert Parry, former president of the San Francisco Fed, said after the decision. ``If it looks like they should tighten further, they will.''

The FOMC's decision left the target for the overnight lending rate between banks at the highest level since March 2001. Richmond Fed President Jeffrey Lacker opposed the move, arguing instead for a quarter-point increase.

Dangers Persist

``Some inflation risks remain,'' the FOMC statement said. ``The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.''

The yield on two-year Treasury notes fell, while the yield on 30-year notes edged higher, a sign investors see inflation picking up. Stocks dropped after the Fed suggested it may not be finished raising interest rates.

The majority of economists expected today's decision after a report on Aug. 4 showed U.S. employers added fewer jobs than forecast in July and the unemployment rate rose. Bernanke laid the groundwork for a pause on July 19, when he told Congress the Fed must be mindful of effects of past decisions still ``in the pipeline.''

Slackening Expansion

In addition, the government released its first official tally of second-quarter growth last month. The U.S. economy expanded at a 2.5 percent annual pace in the period, less than half the rate of the first three months of 2006.

``The high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures,'' the statement said. ``However, inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions.''

Today's move ends the Fed's longest streak of increases without a pause or cut since the FOMC began announcing the direction of moves in the target rate in 1994. The rate was 1 percent when policy makers began a series of 17 consecutive quarter-point moves in June 2004.

Fed policy makers are taking advantage of the first clear opportunity to pause since Bernanke in April explicitly said central bankers may soon do so. New data show slower economic and job growth, while a drop in Treasury yields over the past month indicates investors are acknowledging the situation and expecting the Fed to take a break from rate increases.

Yet by pausing now, Fed officials may be risking an even higher rate of inflation if their forecast is wrong. The Fed's preferred gauge, which excludes food and energy costs, increased 2.4 percent in June from a year earlier, the fastest clip since September 2002. Bernanke and other officials have said they're comfortable with inflation between 1 percent and 2 percent.

Productivity

Also, in the second quarter, U.S. productivity gains eased and labor costs rose the most since the end of 2004, the Labor Department said in a report today, suggesting rising wages may exacerbate a pickup in inflation.

Because of the surge in energy costs, the Fed isn't as far ahead of inflation as at the past two interest-rate peaks under Bernanke's predecessor, Alan Greenspan. At 5.25 percent, the fed funds rate is about 1 percentage point above the full measure of the consumer price index, compared with about 3 points in late 2000 and early 1995.

``It's very likely they're going to be forced into a few more interest-rate increases during the fall, and that will come because the inflation data will not come in as tame as the statement suggests,'' said Stephen Cecchetti, a former research director at the New York Fed.

Bernanke's Credibility

Bernanke must retain credibility in the face of rising inflation by publicly stating that the economy will slow in a ``significant'' way, said Cecchetti, now a professor of economics at Brandeis University in Waltham, Massachusetts.

Other central banks in the world's largest economies are picking up the pace as the Fed slows down.

The European Central Bank has raised its main rate four times since December to 3 percent after holding it at 2 percent for two years. The Bank of England pushed up its rate Aug. 3 for the first time in two years. The Bank of Japan raised borrowing costs for the first time in almost six years on July 14.

Looking Back

For their part, U.S. policy makers were raising rates from unusually low levels and started doing so well before other countries began to follow. One of the reasons Fed policy makers are pausing now is because they believe the economy hasn't yet seen the full effect of previous increases. Such moves may take three to 18 months to bear fruit, Donald Kohn, vice chairman of the Fed's Board of Governors, said in June.

Key to the slowing economy has been a cooling housing market. Since the Fed began raising rates, the average rate on a one-year adjustable mortgage has jumped to 5.69 percent from 4.13 percent, according to Freddie Mac. The number of unsold homes on the market has almost doubled since January 2005.

Bernanke told Congress last month that the housing slowdown ``so far appears to be orderly.'' Still, San Francisco Fed President Janet Yellen said last week that ``we can't ignore the risks of more unpleasant scenarios developing.''

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net.

Last Updated: August 8, 2006 15:45 EDT