By Howard Schneider and Jason Lange

WASHINGTON (Reuters) - The Federal Reserve's ability to raise interest rates this year may hinge on a rebound in hiring that would convince policymakers the U.S. economy is not faltering, Fed Chair Janet Yellen told lawmakers on Tuesday.

In testimony before Congress that expressed general optimism about the economy and played down the risk of a recession, Yellen nevertheless said the Fed will be cautious about interest rate increases until it is clear the job market is holding up.

Immediate risks, like the potential fallout from Britain's June 23 vote on whether to leave the European Union, could darken the U.S. economic outlook, she told the Senate Banking Committee, as could a downturn in productivity growth that may prove a permanent drag on the economy.

"Without a doubt, in the last several months a number of different metrics suggest ... a loss of momentum in terms of the pace of improvement," Yellen said. "We believe that will turn around, we expect it to turn around, but we are taking a cautious approach and watching very carefully to make sure that that expectation is borne out before we proceed to raise interest rates further."

Her comments suggest the U.S. central bank is unlikely to raise rates at its next policy meeting in late July, since it will only have one additional monthly employment report in hand by that time.

They also demonstrate how a new sense of uncertainty has taken root as Fed policymakers come to grips with a broadening realization that the economy's potential appears to be weaker than previously thought.

In a generally civil 2-1/2-hour hearing, Yellen was questioned less about those long-run economic issues and more about the immediate economic and political concerns of panel members: why agricultural prices were so low, why there were so many white men in charge of the Fed's regional reserve banks, and why there was so much income inequality.

Asked about presumptive Republican presidential nominee Donald Trump's suggestion the United States could lower its national debt by buying back securities at a discount, Yellen said any move that smacks of a default for a security generally viewed by the world as risk-free would have "severe" consequences.

Her comments largely tracked the Fed's policy statement last week and the press conference that followed.

"It's a rehash. The underlying message is a continuation of the trend that the Fed is moving toward a more cautious stance to support this economic expansion with the fragility of the economic backdrop," said Robert Tipp, chief investment strategist at Prudential Fixed Income in Newark, New Jersey.

U.S. Treasury yields had risen to session highs by the end of Yellen's testimony, while stocks on Wall Street were trading higher. U.S. rates futures implied traders saw a 12 percent chance of the Fed raising rates in July, little changed from Monday. The dollar <.DXY> was stronger against a basket of currencies.


There was more explicit attention during Yellen's testimony to the possible implications of the "Brexit" vote, which she said could have "significant repercussions."

Asked if Britain's departure from the EU could trigger a recession in the United States, Yellen said: "I don't think that is the most likely case, but we just don't really know what will happen and we will have to watch very carefully."

Although the outcome of the British referendum will be known this week, the jobs issue may take longer to sort out.

Fed officials have said they expected U.S. job growth to slow from the average 200,000 per month typically seen during the post-financial crisis recovery. But the drop to an average of 80,000 in April and May was particularly sharp and put the economy below the level of job creation the Fed considers necessary to accommodate new labor force entrants.

In her testimony, Yellen called the slowdown likely a "transitory" phenomenon.

But concerns the hiring slowdown may be longer-lasting, coupled with a lowered sense of U.S. economic potential, mean the Fed's benchmark overnight interest rate is likely to remain low "for some time" Yellen said.

Current Fed policymakers' projections foresee two rate increases this year and three each in 2017 and 2018, a slower pace from what was forecast in March.

Yellen will appear before a House committee on Wednesday to complete her semi-annual testimony before Congress.

(Reporting by Howard Schneider; Additional reporting by Richard Leong and Jonathan Spicer in New York, Lucia Mutikani and Lindsay Dunsmuir in Washington and Ann Saphir in San Francisco; Editing by Paul Simao)