Fed nods to firmer inflation, still focused on labor weakness

By Michael Flaherty

WASHINGTON (Reuters) - The Federal Reserve on Wednesday upgraded its assessment of the U.S. economy, taking note of a decline in the jobless rate and signaling more comfort that inflation was moving up toward its target.

Still, after a two-day meeting, Fed policymakers reiterated concerns about slack in the labor market and reaffirmed that it is in no rush to raise interested rates.

As widely expected, the central bank cut its monthly asset purchases to $25 billion from $35 billion, leaving it on course to shutter the program this fall.

"Labor market conditions improved, with the unemployment rate declining further," the Fed said in a statement. "However, a range of labor market indicators suggests that there remains significant underutilization of labor resources."

U.S. stocks turned modestly higher after the statement was released, while government bond prices extended earlier losses that had been spurred by a stronger-than-expected reading on economic growth. The dollar hit a session high against the yen.

Interest rate futures clung to the view that the Fed would raise borrowing costs from near zero in June of next year.

"The fact that officials still see excess slack in the labor markets as noteworthy suggests a high level of comfort with leaving rates very low," said Omer Esiner, chief market strategist at Commonwealth Foreign Exchange in Washington.

The Fed's policy-setting panel dropped a phrase from its last policy statement in June that had described the jobless rate as "elevated." Its emphasis on slack, however, indicated officials were looking at a broader range of indicators of the health of the jobs market and were still dissatisfied.

INFLATION MOVING TOWARD TARGET

As notable was the growing comfort officials signaled on inflation, which they had long worried was running too low.

"The committee ... judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat," the Fed said.

Taken together, the shifts in the Fed's statement marked a small step toward an eventual rate hike. The Fed has kept overnight rates near zero since December 2008 and has more than quadrupled its balance sheet to $4.4 trillion through a series of bond purchase programs.

The Fed reiterated that it would likely keep rates near zero for a "considerable time" after its bond buying ends and restated that an "accommodative" policy was needed.

The government on Wednesday said the U.S. economy grew at a 4 percent annual rate in the second quarter, a figure that likely amplified the debate within the Fed about how soon rates should rise.

Some Fed officials have expressed concern that the central bank risks overstaying its welcome with low rates and fueling an unwanted level of inflation. Others, including Fed Chair Janet Yellen, have argued that considerable slack remains in the economy and are wary of moving too soon.

Although Yellen believes the nation's 6.1 percent unemployment rate overstates the health of the jobs market, she warned earlier this month that a rate hike could come "sooner and be more rapid than currently envisioned" if labor markets continue to improve more quickly than anticipated.

Payrolls processor ADP said on Wednesday U.S. companies hired 218,000 workers in July, a solid pace but a bit short of economists' forecasts. A more comprehensive report on Friday is expected to show nonfarm payrolls increased by 233,000 in July, which would mark the sixth straight month with job growth above 200,000.

(Reporting by Michael Flaherty; Editing by Andrea Ricci and Meredith Mazzilli)