The U.S. Federal Reserve (search)'s policy-setting panel, as expected, left short-term interest rates unchanged at its regularly scheduled meeting Tuesday, but opened the door to a possible rate reduction in the future in the event that business conditions take a turn for the worse.

Fed Chairman Alan Greenspan (search) and his Federal Open Market Committee (search) colleagues opted for now to keep the federal funds rate (search) at 1.25 percent, its lowest level since 1961. The funds rate is the interest banks charge each other on overnight loans and is the Fed's primary tool for influencing economic activity.

Holding the funds rate steady means that commercial banks' prime lending rate (search) -- the benchmark for many consumer loans -- will also remain at 4.25 percent, the lowest level since 1959.

In a complex post-meeting statement, the Fed's rate-setting Federal Open Market Committee said risks to the economy were tilted toward weakness and -- for the first time -- it warned of a small chance of "an unwelcome substantial fall in inflation."

Analysts said the Fed evidently sees multiple threats to an expansion but has chosen to wait and see, at least for now, whether a hoped-for acceleration in economic activity takes hold relatively quickly.

"They decided to go to an easing bias because there are two risks: first, possible deflation is a real concern. And second, the economic data we've seen so far have been much weaker than expected, especially in manufacturing and the labor market," said Sung Won Sohn, chief economist at Wells Fargo & Co. in Minneapolis.

The FOMC statement restored the "balance of risks" assessment dropped at its last meeting on March 18, but modified it to include a reference to the potential of falling inflation. In March, the FOMC said that pending war with Iraq made gauging the economy's prospects impossible.

The U.S. military's bombing of Iraq began a day after the March meeting.

The FOMC decision kept the trendsetting federal funds rate for overnight loans between banks at 1.25 percent, where it has been since a cut last November. Analysts said the warning about weakness might set the stage for rate cuts in June if economic signals remain weak.

After the Fed decision was announced, Treasury prices rose while stock prices pared gains. The dollar sank against other major currencies, including the euro, apparently in the belief more U.S. rate cuts may lie ahead which would make dollar-denominated assets less appealing to investors.

Fed Chairman Alan Greenspan told Congress last week he expected a healthier pace of expansion ahead, provided business spending gathers steam.

"I continue to believe that the economy is positioned to expand at a noticeably better pace than it has during the past year, though the timing and the extent of that remains uncertain," Greenspan said. Those words were echoed in the post-meeting statement on Tuesday.

The end of the war in Iraq hasn't produced an economic boom -- as some had hoped.

Recent economic signals have been mixed, with signs consumers remain willing to spend but with distinct softness on the job-creation front. Last week, the government said the economy shed 48,000 jobs in April, bringing total job losses to more than half a million from February through April.

Lara Rhame, an economist at Brown Brothers Harriman in New York, said Fed policymakers were forced to concede the economy was weak, whether or not they are contemplating more rate cuts.

"They have got to at some level acknowledge the fact that the economy is quite vulnerable because of job losses," she said.

Reuters and the Associated Press contributed to this report.