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Not ready to 'declare victory,' Fed signals quicker pace on rate increases

The U.S. Federal Reserve raised its benchmark interest rate and signaled it may take a faster path on rate hikes this year.

The central bank's target range for the federal funds rate will now be 1.75% to 2%, up 25 basis points from the previous level, the Federal Open Market Committee said in a statement. The widely expected action marks the Fed's second rate hike of the year.

"The decision you see today is another sign that the US economy is in great shape," Fed Chairman Jerome Powell told reporters. "Growth is strong, labor markets are strong, inflation is close to target."

The median projection from the FOMC also signals more Fed officials now favor increasing the rate four times in total this year, but Fed officials continue to be split on whether that is too aggressive. Eight of the 15 FOMC meeting participants see two or more additional 25-basis-point rate increases as appropriate, while seven think the Fed should take a slower approach.

But overall, analysts say, the FOMC took a more hawkish tone in its post-meeting statement, removing a portion that suggests officials think their monetary policy stance will remain at a level that stimulates the economy "for some time." The Fed now looks "more determined to get to the longer-run neutral policy rate," one that keeps the economy on an even keel without stimulating or restricting growth, BMO Capital Markets chief economist Douglas Porter wrote in a note to clients.

The FOMC also upgraded its view on the U.S. economic outlook, with its statement describing economic activity as "solid" instead of "moderate," wrote Scott Anderson, chief economist at Bank of the West.

"The Fed's rate hike today and revised economic and interest rate projections and statement paint [an] FOMC that is becoming a lot more confident in the sustainability of economic activity in the face of rising interest rates," Anderson wrote in a note to clients.

The rate hike comes as analysts expect inflation will strengthen this year. The central bank's preferred inflation gauge held at 1.8% in April, just shy of its 2% target, but Fed officials anticipate inflation will surpass that goal in the coming months. Powell said inflation has moved "very gradually" toward the 2% goal but said the Fed is "not ready to declare victory" until inflation settles around that figure for a considerable amount of time.

The Fed's projections show officials view inflation ending 2018 at 2%, then see inflation finishing the next two years at 2.1%. They also think the U.S. unemployment rate, which reached a postcrisis low of 3.8% in May, will fall to 3.6% at the end of 2018. That is far below their 4.5% estimate of the longer-run unemployment rate, potentially raising concerns that inflation may rise at an unhealthy pace. Powell, though, said he does not think inflation "will take off" even if the jobless rate stays at historically low levels.

The central bank "can't be too attached" to those longer-run figures given the uncertainty around them, Powell said. For example, he said, the Fed is still "learning about the real location" of the natural rate of unemployment and how low the jobless rate can drop before inflation rises quickly.

He also said his colleagues have a "range of views" on several other issues, such as whether they should be concerned about the flattening yield curve given its reliability in predicting future recessions. Officials also are still not clear on what the longer-term effects of U.S. tax cuts will be, though they generally agree they will "provide meaningful support" to the economy in the coming months.

Fed officials now see the U.S. economy growing by 2.8% this year, up from their previous estimate of 2.7%. They also see GDP rising by 2.4% in 2019, then to 2.0% in 2020.

The ongoing discussions around trade pose a risk to that outlook, he said, noting that the Fed is "beginning to hear reports of companies holding off" on hiring and investments. But that has not yet appeared in the data, he said.

"We really don't see it in the numbers," he said. "It's just not there."

Market participants were largely expecting the Fed's action. Ahead of the meeting, futures markets suggested there was a 96.3% chance of a 25-basis-point hike, according to the CME Group's FedWatch tool.

The central bank also made a technical change to its monetary policy tools, increasing the interest on excess reserves it pays to banks by only 20 basis points, rather than 25. Officials hope the move would bring the effective federal funds rate closer to the midpoint of the Fed's 25-point range, as it has currently been trading at the higher end of it.