By Jason Lange and Howard Schneider
WASHINGTON (Reuters) - The U.S. Federal Reserve left interest rates unchanged on Wednesday but strongly signaled it could still tighten monetary policy by the end of this year as the labor market improved further.
Fed Chair Janet Yellen, speaking after the central bank's latest policy statement, said U.S. growth was looking stronger and rate increases would be needed to keep the economy from overheating and fueling high inflation.
"We judged that the case for an increase has strengthened but decided for the time being to wait," Yellen told a news conference. "The economy has a little more room to run."
Yellen said she expected one rate increase this year if the job market continued to improve and major new risks did not arise.
The Fed kept its target rate for overnight lending between banks in a range of 0.25 percent to 0.50 percent, where it has been since it hiked rates in December for the first time in nearly a decade.
The central bank has appeared increasingly divided over the urgency of raising rates. On Wednesday, Kansas City Fed President Esther George, Cleveland Fed President Loretta Mester and Boston Fed President Eric Rosengren dissented on the policy statement, saying they favored raising rates this week.
At the same time, policymakers cut the number of rate increases they expect this year to one from two previously, according to the median projection of forecasts released with the statement. Three of the 17 policymakers said rates should remain steady for the rest of the year.
The Fed also projected a less aggressive rise in interest rates next year and in 2018, and cut its longer-run interest rate forecast to 2.9 percent from 3.0 percent.
Investors did not appear to significantly shift their bets on the timing of the next rate hike. Prices for fed funds futures contracts suggested investors continued to see just better-than-even odds of a hike at the December policy meeting, and almost no chance of an increase in November.
U.S. stock prices rose after the Fed released its statement.
The dissents from those wanting a hike this week suggested to some economists that pressure was building.
"While the Federal Reserve held rates unchanged, the highly unusual 7-3 vote points to the depth of its policy dilemma and makes a December hike more likely," said Mohamed El-Erian, chief economic adviser at Allianz.
FOCUS ON DECEMBER
Last December, the Fed signaled that four rate increases were likely in 2016, but that was scaled back in March due to a global growth slowdown, financial market volatility and concerns about tepid U.S. inflation.
The central bank appeared more confident on Wednesday, saying in its statement that near-term risks for the economic outlook "appear roughly balanced." That means policymakers think the economy is about as likely to outperform forecasts as to underperform them.
The economy expanded sluggishly in the second quarter and added fewer jobs than expected in August. Inflation also showed signs of stirring last month.
The Fed's decision, which came the same day that Japan's central bank added a long-term interest rate target to its massive asset-buying program in an overhaul of its policy framework, was widely anticipated by economists.
A Reuters poll showed the median probability of a September rate rise was about 25 percent. Only 6 percent of those surveyed expected the Fed to raise rates, with the majority believing it would wait until December.
The Fed has policy meetings scheduled in early November and mid-December. Economists believe policymakers would avoid a rate hike in November in part because the meeting falls just days before the U.S. presidential election.
(Reporting by Jason Lange, Lindsay Dunsmuir and Howard; Schneider; Editing by David Chance and Paul Simao)