Fed renews low rate promise, upbeat on economy

Against the backdrop of rising financial turmoil in Europe, the U.S. central bank held benchmark borrowing costs in a zero to 0.25 percent range but said consumer and business spending were picking up steam.

Economic activity has continued to strengthen and ... the labor market is beginning to improve, the Fed said in its policy statement, an upgrade from a March description of employment as merely stabilizing.

Still, the Fed flagged a continued reluctance on the part of employers to add new workers.

Financial markets were too fixated on the troubles of Greece, Portugal and Spain, which all faced ratings downgrades this week, to pay the Fed's decision much mind. But the central bank's cautious optimism did offer some support to U.S. stocks, which rose modestly in late afternoon, recovering from Tuesday's drop.

As long as inflation remains very low there's little incentive for the Fed to remove stimulus, said Omer Esiner, senior market analyst at Travelex Global Business Payments in Washington. Moreover, the worsening of the situation in Europe ... will restrain Fed hawks a bit.

SUBDUED INFLATION

The Fed reiterated a closely watched statement that rates were likely to remain exceptionally low for an extended period because of low inflation and high unemployment.

Inflation is likely to be subdued for some time, the Fed said.

Kansas City Federal Reserve Bank President Thomas Hoenig dissented for a third consecutive meeting because he opposed the ultra-low rates pledge on the grounds that it could lead to a build-up of future imbalances.

He also worried it could curb the Fed's flexibility to raise rates if and when needed.

The U.S. economy has been expanding since last summer, emerging more quickly than anticipated from its deepest recession since the Great Depression. Gross domestic product rose at a 5.6 percent annual rate in the fourth quarter, and is forecast to have climbed at a 3.4 percent pace in the first three months of this year.

Employment gains have been harder to come by. With the unemployment rate stuck at 9.7 percent, some Fed officials are anxious about the sustainability of the economic rebound.

The pace of economic recovery is likely to be moderate for a time, the Fed said, repeating a phrase it employed after its last two meetings in January and March.

In response to the recession and worst financial crisis in generations, the Fed slashed interest rates and undertook a series of emergency measures to help fractured credit markets.

Despite some speculation that the central bank might openly refer to the possibility of asset sales, the statement contained no such mention, although that does not necessarily mean the matter was not discussed.

The Fed's interventions have had some success in restoring financial stability, but scars from the crisis are still visible.

Instead of the subprime mortgages that saddled homeowners and banks with bad debts, current worries focus on the heavy debt loads of some euro zone nations and the possibility their woes could be the precursor to a broader sovereign debt crisis among advanced nations.

Ratings agency S&P downgraded Spain on Wednesday, a day after cutting Greek and Portugal's debt grades almost in tandem, sending global markets into a tailspin. European stocks have fallen more than 6 percent in less than two weeks.

In recent weeks, Fed officials have said the debt troubles in Greece and some other euro zone nations were not yet directly affecting the U.S. outlook, though they continue to watch for signs of a renewed liquidity crunch.

The Fed would act when the contagion in European financial markets is beginning to impact U.S. financial markets, said Joseph Brusuelas, chief economist at Brusuelas Analytics in Stamford, Connecticut.

Money markets showed the first signs of stress on Wednesday as fallout from the euro zone government debt crisis spread, with some banks finding access to liquidity becoming more difficult.

(Additional reporting by Emily Kaiser and David Lawder; Editing by Kenneth Barry)