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.
The Fed said U.S. economic activity had picked up and job gains were "solid" in recent months.
"The case for an increase in the federal funds rate has strengthened," the U.S. central bank said in a statement following a two-day policy meeting.
It added that its rate-setting committee had decided against raising rates "for the time being," until there was more evidence of progress toward its employment and inflation objectives.
The Fed has held its target rate for overnight lending between banks in a range of 0.25 percent to 0.50 percent since December, when it raised borrowing costs 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.
But in a sign of growing confidence, the Fed said the 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.
Investors reacted with skepticism to the shallower rate path projections. U.S. short-term interest rate futures trimmed earlier losses and some nearer-term maturities rose on Wednesday. Before the rate decision, traders saw about a 58 percent chance of a December rate hike, and were betting on another hike in 2017.
The dissents from those wanting a hike 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 (DE:ALVG).
Fed Chair Janet Yellen was due to hold a press conference at 2:30 p.m. EDT (1830 GMT).
FOCUS ON DECEMBER
The Fed in December signaled that four rate increases were likely this year, but that was scaled back in March due to a global growth slowdown, financial market volatility and concerns about tepid U.S. inflation.
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.