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Fed report strikes familiar tone, signaling need for further gradual rate hikes

The Federal Reserve struck a familiar tone in its semiannual monetary policy report, saying the economy is continuing to gather steam, the labor market is tightening and further increases in interest rates are needed to keep the expansion going.

The report, the first under Chairman Jerome Powell, says businesses and households are more optimistic about the economy, partly due to low borrowing costs, increased household wealth and a steady pace of job growth.

Still, the report noted that wage growth has remained modest since the financial crisis, even as the labor market continues to tighten and "appears to be near or a little beyond full employment." That is likely due to "persistently weak productivity growth," the report says, listing the vast range of opinions from economists about what explains that trend.

Inflation, meanwhile, remains below the Fed's 2% target, with its preferred gauge rising by 1.5% year over year in December 2017. The report attributes at least part of the weakness to temporary events in early 2017 that will be stripped out of the annual readings in the coming months. Inflation, the report added, will stabilize around the Fed's 2% target "over the next few years."

Many participants at the Federal Open Market Committee think that gradual interest rate hikes are appropriate over the next few years. In December 2017, the median FOMC projection suggested that the Fed has penciled in three rate hikes for 2018.

"This view was predicated on several factors, including a judgment that the neutral real interest rate was currently low and would move up only slowly, as well as the balancing of risks associated with, among other things, the possibility that inflation pressures could build if the economy expands well beyond its long-run sustainable level, and the possibility that the forces depressing inflation could prove to be more persistent than currently anticipated," the report says. "As always, the actual path of the federal funds rate will depend on evolving economic conditions and their implications for the economic outlook."

Fears from some investors that inflation will finally start seeing major gains contributed to a recent sell-off in the equities market, though Fed officials have largely downplayed those moves. The report also seemed to downplay the market volatility, noting that U.S. stock indexes are still higher than they were last summer "notwithstanding financial market developments in recent weeks." Stock price increases, it noted, are generally higher in all industries outside of utilities and real estate, which underperform in an environment of rising interest rates.

The report also said there do not appear to be major vulnerabilities in the U.S. financial system, though it suggested several asset values such as stocks and real estate may be elevated. Banks' capital and liquidity ratios are strong and still improving, the report says, and liquidity risks have dropped partly due to regulations implemented after the financial crisis.

Powell will testify in two House and Senate committees next week about the report.