The Fed now predicts the economy will shrink between 1 and 1.5 percent this year, an improvement from its old forecast issued in May. At that time, the Fed projected the economy would contract between 1.3 and 2 percent.
The upgrade comes from the expectation that the economy's downhill slide in the first half of 2009 wasn't as bad as previously thought. The Fed said the economy should start growing again in the second half of this year, although the pace is likely to be plodding.
Most Fed policymakers said it could take "five or six years" for the economy and the labor market to get back on a path of full health in the long term.
Against that backdrop, the Fed's forecast for unemployment this year worsened. The central bank predicted the jobless rate could rise as high as 10.1 percent, compared with the previous forecast of 9.6 percent.
The nation's unemployment rate climbed to 9.5 percent in June, a 26-year high.
The predictions are based on what the Fed calls its "central tendency," which exclude the three highest and three lowest forecasts made by Fed officials. The central bank also gives a range of all the forecasts. That range showed that some officials expect the jobless rate could rise as high as 10.5 percent this year, and 10.6 percent in 2010. The post-World War II high was 10.8 percent at the end of 1982, when the country had suffered through a severe recession.
For 2010, the Fed predicted the economy would grow between 2.1 and 3.3 percent. That's a slight upgrade from its old forecast of growth between 2 and 3 percent.
Still, it would mark a slow recovery and that will keep unemployment elevated well into 2011, the Fed said. Companies won't be in any mood to ramp up hiring until they are certain that any recovery has staying power.
To help lift the country out of recession, the Fed has slashed interest rates to a record low near zero. In March, the Fed launched a $1.2 trillion effort to drive down interest rates to revive lending and get Americans to spend more freely. Those actions along with President Barack Obama's $787 billion stimulus package of tax cuts and increased government spending should help the economy return to growth in the second half of this year, the Fed said.
At its last meeting in late June, Fed Chairman Ben Bernanke and his colleagues pledged to hold its key bank lending rate near zero for an extended period of time to help brace the economy. Many analysts believe the Fed will leave rates at record lows through the rest of this year.
The Fed last month also decided against expanding its $1.2 trillion program of buying government bonds and mortgage-backed securities to drive down rates on mortgages and other consumer debt.
Part of the reason the Fed stayed the course was out of fear that expanding the programs could stir up investor fears that the central bank's aggressive actions could spur inflation later on, documents of the closed-door June meeting indicated. In addition, "it seemed that economic activity was in the process of leveling out."
On the inflation front, Fed policymakers did bump up their forecasts for this year and next. The Fed expects inflation to rise between 1 and 1.4 percent in 2009, reflecting the influence of higher oil and commodity prices. The old forecast called for a gain of between 0.6 and 0.9 percent this year.
Even with the projected pickup, the Fed believes inflation "would remain subdued for some time." That's because the sluggish recovery, idle plants, a weak employment market and cautious consumers will restrain companies from jacking up prices.
Next year, inflation should rise between 1.2 and 1.8 percent, the Fed said. That's up from the old forecast of between a 1 and 1.6 percent gain.