Dec. 13 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and his colleagues are edging away from their threat to raise interest rates.

The Federal Open Market Committee yesterday took what some economists saw as small steps toward a rate reduction in 2007, noting a ``mixed'' economic performance and describing the year- long housing slump as ``substantial.'' The Fed hedged by repeating, verbatim, warnings that inflation remains a threat.

``This is the beginning in the change of the tone, which will ultimately set up a rate cut,'' said Stuart Hoffman, chief economist at PNC Financial Services Group Inc. in Pittsburgh. ``This is a baby step in that direction.''

The language reinforced speculation among traders that a reduction is penciled in by June. Before cutting, the Fed would need to weigh weakness in housing and manufacturing against an expanding labor market and rising wages.

Policy makers voted 10-1 to leave the benchmark lending rate at 5.25 percent for the fourth straight meeting. They pushed borrowing costs higher for two years through June.

``They did move somewhat toward a more symmetric stance or one that would even be eventually consistent with easing,'' said Peter Kretzmer, a senior economist at Bank of America Corp. in New York, who forecasts two quarter-point cuts next year. ``There are definitely some indications out there of a loss of momentum.''

Rate Futures

Traders raised bets after yesterday's decision that the Fed will cut its main rate a quarter-point by the end of May. The probability rose to 67 percent, from 59 percent, based on futures prices tied to the rate on the Chicago Board of Trade. It dropped to 49 percent today after a stronger-than-expected report on retail sales.

The yield on the two-year Treasury note rose 5 basis points to 4.67 percent today after falling a similar amount yesterday.

Bernanke, who turns 53 today, appeared comfortable with the outlook in his most recent remarks on the economy. ``Outside of the housing and motor vehicle sectors, economic activity has, on balance, been expanding at a solid pace,'' he said in a Nov. 28 speech. ``In the case of inflation, the risks to the forecast seem primarily to the upside.''

The Fed yesterday updated its economic outlook to say the housing market has undergone a ``substantial cooling'' and that ``recent indicators have been mixed'' in the broader economy. The FOMC added that growth will come at a ``moderate pace on balance over coming quarters,'' providing more detail than the prior statement.

Above the Range

Even so, prices outside of food and energy are still rising at a pace that's above what Bernanke and other Fed officials identify as their ``comfort'' range of 1 percent to 2 percent.

As measured by the Fed's preferred inflation gauge, consumer prices rose 2.4 percent in October from a year earlier, just below the 2.5 percent reported in August, the fastest pace since April 1995. The rate was 2 percent when Bernanke took office in February.

``It would be premature at this stage of the game'' to assume the Fed is leaning toward lower borrowing costs, said Diane Swonk, chief economist at Mesirow Financial Inc. in Chicago. ``The Fed has nothing to gain by declaring victory until inflation is in its comfort zone. It is different to acknowledge the slowdown than to balance the risks.''

One policy maker continued to advocate tighter credit. Richmond Fed President Jeffrey Lacker cast his fourth straight dissenting vote, making him the first member to have such a streak since Cleveland Fed President Jerry Jordan bucked the consensus four consecutive times in 1998.

Lacker, 51, won't vote again at the FOMC until 2009. Among next year's voters is the Chicago Fed's Michael Moskow, 68, who stressed the possibility of higher rates on Dec. 1.

Manufacturing Shrinks

Since the Fed's last meeting Oct. 24-25, new economic data provided the ``mixed'' signs cited by the Fed yesterday. Orders for U.S. durable goods declined in October by the most in more than six years, while manufacturing in the U.S. shrank last month for the first time in more than three years.

Keith Hembre, chief economist at Minneapolis-based U.S. Bancorp's FAF Advisors Inc., which manages $98 billion, said the Fed had little choice but to acknowledge the economic weakness.

``If they didn't, they would start to look like they were not in touch with reality,'' said Hembre, a former economist at the Minneapolis Fed. ``That said, I don't think they're particularly comfortable with the easiness of financial-market conditions right now, and they don't want to encourage expectations of a near-term easing.''

Job Growth

Policy makers are getting few clues from the labor market to warrant a shift. Last week, the Labor Department said U.S. employers added 132,000 jobs in November and averaged 138,000 in the past three months. The jobless rate inched up to 4.5 percent from 4.4 percent, which was a five-year low.

The Commerce Department reported today that retail sales excluding motor vehicles rose 1.1 percent in November from the previous month, the most since January.

``Time will tell if the market has discounted too many rate cuts,'' said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``The growing signs of weakness are disturbing, and at some point soon, the Fed may need to move to a neutral bias, perhaps as soon as the January meeting.''

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

Last Updated: December 13, 2006 09:41 EST