June 28 (Bloomberg) -- The Federal Reserve kept the benchmark U.S. interest rate at 5.25 percent and stressed in new language that inflation is the greatest risk facing the economy.

``Readings on core inflation have improved modestly in recent months,'' the Federal Open Market Committee said today after a two-day meeting in Washington. ``However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated.''

By playing down the recent slowing of inflation, the central bank dashed the hopes of some traders that policy makers would prepare the ground for a rate cut. The Fed, which has kept borrowing costs unchanged for a year, repeated its warning that a tight job market may sustain price pressures.

``The committee's predominant policy concern remains the risk that inflation will fail to moderate as expected,'' the Fed said. Turning to growth prospects, the Fed said the economy is ``likely to continue to expand at a moderate pace over coming quarters.''

Stocks surrendered gains and Treasury notes declined.

Since the FOMC last met on May 9, reports have signaled a rebound from last quarter's annual growth rate of 0.7 percent, the weakest in four years. The expansion will likely exceed 3 percent in April to June, according to JPMorgan Chase & Co., Morgan Stanley and HSBC Securities USA Inc.

Praise for Fed

Ben S. Bernanke, now in his sixteenth month as chairman, kept a majority of voting members focused on the central bank's forecast. Economists made a case for both a rate cut and an increase in recent months based on the inflation and housing data.

``They do face a problem if inflation stays where it is,'' Stephen Cecchetti, a professor of international economics at Brandeis University in Waltham, Massachusetts, and a former director of research at the New York Fed. ``That is why they have been working so diligently to bring it down.''

Bernanke also weathered internal dissent. Richmond Fed President Jeffrey Lacker broke ranks and voted in favor of higher rates when the Fed paused in August. Lacker kept voting for increases over the next three meetings.

Fed officials also revisited their forecasts for growth, employment and prices at today's meeting. The outlook will be published next month during Bernanke's semi-annual testimony before Congress.

Preferred Inflation Gauge

The Fed's preferred inflation measure, the personal consumption expenditures price index minus food and energy, slowed to 2 percent in April, down from 2.4 percent in February, a level that matched a four-year high. The price gauge rose at an annual pace of 2.4 percent in the first quarter, the Commerce Department reported today, faster than the 2.2 percent previously estimated. Price data for May will be released tomorrow.

``We still have a problem with lagging inflation,'' said William Rhodes, senior vice chairman of Citigroup Inc. in New York. ``The Fed is steady as she goes.''

Central bankers aren't relaxing their guard yet because ``they are still at the outer limit'' of the comfort zone of 1 to 2 percent, said Lou Crandall, chief economist at Wrightson ICAP LLC, in Jersey City, New Jersey.

What's more, their inflation scorecard will be re-written at the end of next month when inflation data is revised for the last three years.

`Risks Are Tilted'

Firm commodity prices, a robust global expansion, and a weaker dollar also mean the ``risks are tilted'' toward firmer prices, Crandall said. The JOC-ECRI Index, which tracks 18 industrial materials such as cotton, burlap, and steel, is up 8 percent this year.

The future of housing markets is likely to be the main source of divergences in the outlook, he added. ``There was one major macroeconomic surprise in the first half of the year,'' Crandall said. ``The double-dip in housing activity.''

Purchases of new homes fell 1.6 percent last month to an annual pace of 915,000, the Commerce Department reported Tuesday, and housing prices in 20 cities in April fell by the most in at least six years, according to S&P/Case-Shiller.

Residential investment, a component of gross domestic product accounts that includes everything from major remodels to new home construction, has dropped for six consecutive quarters, the longest slump since 1989-1990.

In May, Fed officials said housing was likely to ``weigh heavily on economic activity'' for most of the year, ``somewhat longer than previously expected.''

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net

Last Updated: June 28, 2007 16:13 EDT