Associated Press Pat Dempsey, center, trades in the Fed Pit at the Chicago Board of Trade yesterday in Chicago. The Federal Reserve left a key interest rate unchanged yesterday and began preparing Americans for the possibility that short-term rates will increase this year as the country bounces back from recession.

WASHINGTON - The Federal Reserve left a key interest rate unchanged yesterday and began preparing Americans for the possibility that short-term rates will go higher this year as the country bounces back from recession.

After 11 consecutive rate reductions last year, Fed Chairman Alan Greenspan and his colleagues opted to continue to hold the federal funds rate - the interest that banks charge each other on overnight loans - at 1.75 percent, the lowest level in 40 years. The decision was announced after a closed-door meeting.

Stocks fell after the announcement.

In January, the Fed, citing signs of an economic rebound, ended a yearlong stretch of uninterrupted credit easing when it left the funds rate unchanged.

Yesterday, the Fed policy-makers were even more upbeat about the economy's prospects.

"The economy, bolstered by a marked swing in inventory investment, is expanding at a significant pace," the Fed said in a statement explaining its decision.

"Nonetheless, the degree of the strengthening in final demand over coming quarters, an essential element in sustained economic expansion, is still uncertain," the Fed added.

The Fed's decision means that commercial banks' prime lending rate, the benchmark for millions of consumer and business loans, will continue at 4.75 percent, a level last seen in November 1965.

Reflecting increased optimism, Fed policy-makers moved to a neutral policy directive, which means they believe risks to the economy are balanced equally between economic weakness and the threat of inflation. For more than a year as the country slid into recession, the Fed had said the greatest risk facing the economy was slow growth.

In explaining its policy shift, the Fed said: "The risks are balanced with respect to the prospects for both goals."

Economists view that as the first step toward preparing consumers and businesses - enjoying the lowest interest rates in a generation - for the possibility that interest rates may go up later this year.

Previously, the Fed's policy stance had given more attention to the economy's shortfalls. Until yesterday's change, the Fed's policy directive had been tilted toward risks of economic weakness, leaving the door open to interest rate cuts.

The decision was unanimous.

"A lot of people and businesses fear rising interest rates. But it is a fact that rising rates are more of a reflection of better economic performance and better prospects for the economy," said economist Ken Mayland of ClearView Economics. He believes the Fed will begin boosting rates this fall, though many other analysts are predicting that higher interest rates will come sooner.

The Fed's 11 interest rate cuts last year may have rescued the economy from the downturn that began in March and will allow healthy economic growth to return in the months ahead, economists say.

Recent economic data suggest the recovery is gaining momentum. The nation's manufacturing sector, which lost hundreds of thousands of jobs during the recession as factories throttled back production, is mounting a comeback.

Also, companies that had been shedding workers to cope with the downturn added jobs in February for the first time in seven months and helped push the unemployment rate down to 5.5 percent, the lowest jobless rate since October.

Many economists believe Fed policy-makers will begin raising rates either at their May 7 or their June 25-26 meetings. That would mark the first rate increase in two years. Some are forecasting the federal funds rate will rise to around 3 percent and the prime to around 6 percent by the end of this year. Such rates still would allow the economy to grow and would remain favorable to many borrowers, analysts said.

In his most upbeat assessment of the economy in more than a year, Greenspan told Congress this month that a recovery was "already well under way" for the country, bruised by the Sept. 11 terrorist attacks and the recession.

The economy bounced back with a 1.4 percent growth rate in the fourth quarter of 2001, after shrinking at a 1.3 percent rate after the terror attacks.