Fed nods to easing inflation, but still worried

WASHINGTON (Reuters) - The Federal Reserve on Thursday held benchmark U.S. interest rates steady and, while nodding to a recent easing in core inflation, restated that inflation is its top concern.

The decision by the central bank's Federal Open Market Committee keeps the overnight federal funds rate target at 5.25 percent, the level it hit in June last year after 17 straight quarter-percentage point increases.

In a statement outlining its decision, the U.S. central bank dropped a reference to core inflation as "elevated" that had been in its two prior rate announcements. Nonetheless, it expressed concern that an easing in the pace at which nonfood, nonenergy prices were rising could prove fleeting.

"Readings on core inflation have improved modestly in recent months," the FOMC said. "However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated."

"The committee's predominant policy concern remains the risk that inflation will fail to moderate as expected," it said in an echo of prior announcements, adding that tight economic conditions were keeping that risk alive.

The dollar held steady but prices for stocks and U.S. government bonds slipped on the announcement, as traders saw the Fed's lingering discomfort with inflation as pointing to less likelihood of a cut in interest rates later this year. The Dow Jones industrial average .DJI, which was up ahead of the Fed's statement, closed marginally lower.

"With the labor market tight and financial conditions still loose, we don't the think the Fed's inflation concerns will be put to rest any time soon," MKM Partners said in an analysis.

Chances of a rate cut by year end, as implied by short-term interest rate futures, slid to 15 percent from 22 percent earlier in the day and more than 50 percent on Wednesday.

INFLATION MODERATES MORE THAN FED

Core inflation did moderate in May and April, coming within range of the 1 percent to 2 percent "comfort zone" of some Fed officials.

While the speed with which core inflation has eased has come as a surprise, the Fed had expected it to move lower over time with the economy moving ahead sluggishly on the back of a big slide in the housing sector.

"Economic growth appears to have been moderate during the first half of this year, despite the ongoing adjustment in the housing sector," the Fed said. "The economy seems likely to continue to expand at a moderate pace over coming quarters."

However, officials have remained concerned that a tight labor market could force employers to boost wages to find and retain workers. In May, the unemployment rate held at a low 4.5 percent.

In addition, overall inflation climbed sharply in May, spurred by higher food and energy prices, which could feed through to prices elsewhere.

Adding to inflation angst, the government's final estimate of first-quarter growth data released on Thursday put core inflation higher than previously believed in the January-March period.

At the same time, the Fed has had to weigh lingering concerns about economic weakness as problems in U.S. mortgage markets have delayed a housing recovery and caused stresses in financial markets.

A rise in long-term interest rates that has pushed up the cost of buying a home adds to obstacles.

U.S. output expanded at a scant 0.7 percent annual rate in the first quarter, but robust hiring in May and signs of a resurgence in factory activity have pointed to stronger growth in the current quarter.

However, an unexpectedly big tumble in May orders for long-lasting goods announced by the government on Wednesday raised questions about the strength of the factory sector and business investment spending plans.

Fed officials used this week's meeting in part to prepare their semiannual economic report to Congress. Fed Chairman Ben Bernanke is expected to deliver the report with two days of testimony in mid-July.

(Additional reporting by Joanne Morrison)