By Nick Timiraos 

WASHINGTON -- Federal Reserve Chairman Jerome Powell delivered an upbeat assessment of the economy and said it justified continued interest rate increases. But he opened the door to a potential policy shift and outlined risks if escalating trade tensions result in permanently higher tariffs.

Mr. Powell has mostly sidestepped recent questions on trade policy because he says it is outside of the Fed's responsibilities. He offered words of caution Tuesday at a hearing before the Senate Banking Committee.

"In general, countries that have remained open to trade, that haven't erected barriers including tariffs, have grown faster. They've had higher incomes, higher productivity," said Mr. Powell. "And countries that have gone in a more protectionist direction have done worse."

Mr. Powell affirmed the Fed's plans to continue with gradual rate increases, and he said it was too soon to say if trade disputes might interfere with those plans. The central bank's rate-setting committee "believes that -- for now -- the best way forward is to keep gradually raising" its benchmark short-term rate, he said.

The addition of the qualifier "for now" to Mr. Powell's statement was new, emphasizing that policy decisions aren't on autopilot. The phrase also signaled less certainty about the rate path as the Fed raises its benchmark rate toward a so-called neutral level that neither spurs nor slows growth.

The Fed raised that rate in June by a quarter percentage point to a range between 1.75% and 2%, the second such increase this year. Most Fed officials penciled in a total of at least four rate increases this year and three more next year.

Most of them expect they will need to raise the rate to a neutral level, which could be reached in the next year, but they haven't resolved whether or how much higher to go after that.

The Fed expects recent tax cuts and an increase in federal spending to boost spending and investment at a time when the labor market is already tight. This has put officials on the lookout for signs the economy could be overheating.

Intensifying trade disputes, on the other hand, could hurt business confidence and roil financial markets if U.S. companies face higher prices or supply-chain disruptions.

Senators of both parties raised concerns Tuesday about President Donald Trump's decisions to impose new tariffs on trading partners and threaten more to come, prompting other countries to do the same to the U.S.

If the Trump administration's trade policy in the end "results in lower tariffs for everyone, that would be a good thing," Mr. Powell told lawmakers. "If it results in...higher tariffs across a broad range of traded goods and services that remain that way for a long period of time, that would be bad for our economy and for other economies, too."

Scott Minerd, chief investment officer at Guggenheim Partners, said investors needed to take more seriously the potential for disruptions. "Tariffs are a form of taxation that ultimately is paid not by the exporter, but by the U.S. consumer," he said in a client note. "Markets are clearly spooked."

The Fed has little reason to change course now because history is full of examples of tariffs that have been threatened but never imposed, or imposed only temporarily.

The Fed tries to set rates with an eye toward the economy's performance a year ahead because monetary policy operates with a lag. But the central bank has few examples from recent history of widespread trade disruptions, so Fed officials will have to rely on current data "a little more than we normally would," said Boston Fed President Eric Rosengren in an interview last month.

Trade disputes have mixed implications for Fed policy. On one hand, they could slow economic growth, causing officials to hold off on rate rises. Or tariffs could push up inflation, requiring a steeper path of increases.

"Are they fighting the war against inflation or are they trying to cushion the shock to growth?" said Ethan Harris, chief economist at Bank of America Merrill Lynch. He said the weakness in overall growth, rather than faster price increases, would be the Fed's bigger worry.

Mr. Powell, in a radio interview last week, said the Fed could ignore the price increases from tariffs if officials conclude they represent a one-time rise that won't be incorporated into businesses' and consumers' expectations of future inflation.

Interpreting the price data could grow more complicated because many Fed officials believe inflation should accelerate as unemployment falls, and vice versa. While that relationship was been very weak over the past decade, officials expect that as labor market slack disappears, wages and prices should rise more quickly.

If a tight labor market appears to be pushing wages higher at the same time tariffs are driving up prices, "it's going to be a little bit harder to disentangle," said Mr. Rosengren.

Central bankers like to maintain inflation around 2%, seeing it as a sign of a healthy economy.

Inflation is close to the Fed's 2% target after undershooting it for many years. Consumer prices in May rose 2.3% from a year earlier. Excluding volatile food and energy categories, they rose 2%, according to the Fed's preferred inflation gauge.

Mr. Powell said Tuesday he took comfort from signs that moderate wage growth "is not causing high inflation."

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

July 17, 2018 18:02 ET (22:02 GMT)