The Federal Reserve on Tuesday held benchmark U.S. interest rates steady and said that while tightening credit conditions had increased downside risks facing the economy, inflation was still its main concern.

The decision by the central bank's Federal Open Market Committee kept the overnight federal funds rate at 5.25 percent, the level it hit in June 2006 after 17 straight quarter-percentage point increases.

The decision comes against a backdrop of volatile financial markets and rising default rates in the U.S. subprime mortgage market. Even after a big rebound on Monday, stocks indexes are well below highs notched in mid-July.

The Fed took note of the turbulence as it outlined its thinking, but said it believed the economy was sound.

Although the downside risks to growth have increased somewhat, the committee's predominant policy concern remains the risk that inflation will fail to moderate as expected, the central bank said in a statement.

Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing, it said. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.

Prices for U.S. government bonds and stocks slipped, while the dollar held steady, after the announcement.

As markets worry about exposure to subprime loans, credit conditions have tightened for borrowers, raising the possibility of slowing consumer and business spending.

A spending slowdown would hit the economy at a time when housing markets are struggling to stabilize after big declines in construction and sales.

Some data already suggests growth has downshifted a bit after a strong second quarter.

The government said on Friday that the nation's employers added a modest 92,000 jobs in July, while two private sector reports have shown slower gains in manufacturing and service sector activity.

The Fed has been able to take some comfort recently that its vigilance on prices is paying off, as gauges of core inflation, which strip out volatile food and energy costs, have eased in recent months.

But data on Tuesday showing worker productivity advanced at a slower-than-expected rate in the second quarter, and downward revisions to productivity gains for prior years, fueled concern that the central bank may have to lower its view of the speed limit the economy must observe to keep inflation at bay.

And while the U.S. central bank may feel some relief from moderating core inflation, oil prices that reached a record high $78.77 a barrel on August 1 will keep inflation nervousness alive.

Finally, the labor market, which policy-makers have steadily pointed to as a possible source of price pressure, showed signs of softening in July, with the jobless rate edging up to 4.6 percent from 4.5 percent the prior month.

(Additional reporting by Glenn Somerville)

Inflation