The U.S. Federal Reserve Board will continue to boost interest rates through 2005 and the S&P 500 index will finish the year with a modest gain, Standard & Poor’s Investment Policy Committee said Monday.

The Federal Reserve increased short-term interest rates for the ninth straight time last week, from a 1% a year ago to 3.25%. S&P says the Fed will continue to raise rates even as investors remain divided on the central bank’s future course of action.

The committee projects a 4% Fed funds rate and 4.75% yield on the 10-year Treasury note by the end of 2005. And although the yield curve — the difference between the yield on short and long-term instruments — will likely narrow to 75 basis points (about 35 basis points below its 35-year average), S&P does not believe it portends an impending recession. Rather, this reflects the attractiveness the U.S. offers to global investors in terms of economic and governmental stability.

The committee’s recommended allocation for traditional “balanced” investors is 45% U.S. stocks, 15% foreign equities, 25% short-to-intermediate term bonds and 15% cash. The IPC continues to believe that equities offer a superior risk-adjusted return.

On that count, it predicts that the flagship S&P 500 index will finish the year at 1255, up 3.6% on the year, notwithstanding a dismal first quarter, in which it fell by more than 2.5%. The second quarter was up a meagre 0.9%, to recover some of the loss experienced in the previous quarter. This advance was supported by increases in six sectors, including financials, health care and utilities.

The committee attributes the muted first half stock performance to a projected slowdown in corporate earnings growth, the impact of record energy prices on consumer spending and the sustainability of the Fed’s rate tightening program.

“With the prospect of a turnaround for the S&P 500 emerging since the beginning of the second quarter, investors may be apprehensive about the quarter coming to a close,” says Sam Stovall, Standard & Poor’s chief investment strategist and a member of the Investment Policy Committee. “Moving forward, we believe the combination of still-healthy economic growth, an attractive market valuation and the eventual end to the Fed’s rate-tightening efforts will lead to an end-of-year rally in stocks.”

The committee also forecasts an 11% year-over-year increase in operating earnings in 2005 for the S&P 500, less than half the gain seen in 2004. Energy prices — after having set a record of more than US$60 per barrel — have recently eased, but the IPC thinks elevated oil prices will remain a challenge to consumers and investors. Prices for West Texas Intermediate oil are projected to average nearly US$52/bbl. this year, while moderating to around US$48/bbl. in 2006.

Standard & Poor’s Investment Policy Committee is composed of the financial research firm’s senior analysts and economists, monitors and assesses global equity and capital markets, determining on a weekly basis recommended asset allocations for investment.