By Michael S. Derby

(Reuters) – The Federal Reserve’s latest Monetary Policy Report to Congress, released on Friday, expressed optimism about the economy while highlighting concerns about the financial system.

The report precedes Fed Chair Jerome Powell’s testimony before Congress next week, emphasizing the central bank’s commitment to returning inflation to 2%. It stated that any changes to interest rates will be made after careful evaluation of incoming data, the evolving outlook, and existing risks.

The overall economy is described as robust, supported by a healthier job market and decreasing inflationary pressures. While the financial system is deemed “sound and resilient,” concerns were raised about high valuations in several markets such as equity, corporate debt, and residential real estate. It was noted that valuation pressures increased, and vulnerabilities related to financial leverage remained evident.

The report indicated no broad threats to the economy from the financial system. It mentioned that credit access is generally sound for mid-sized and large businesses, most households, and local governments, although small firms and those with credit issues faced tighter credit conditions.

Overall borrowing levels for households and non-financial firms have decreased significantly compared to the past two decades.

This Monetary Policy Report, published biannually, is based on data available to the central bank as of Thursday and encompasses themes familiar to Fed followers and market participants. It arrives amid a landscape of uncertainty due to extensive policy changes being contemplated or implemented by President Donald Trump.

Last year, the Fed successfully reduced its interest rate target by a percentage point as inflation pressures eased. However, future cuts remain uncertain, especially as Trump’s trade and labor policies could induce rising inflation, contradicting the Fed’s goals.

While the report provided limited insights on Trump’s trade policies, it acknowledged that potential increases in U.S. tariffs might be influencing the dollar’s strength in recent months.

Additionally, the release mentioned that strong productivity might allow for quicker economic growth without inflation pressures. Although emerging AI technology currently has limited impact on productivity, its significance is expected to grow with wider adoption.

While offering little guidance regarding future monetary policy, the report acknowledged that the current federal funds target rate of 4.25-4.50% aligns with policy rule assessments. Although officials don’t strictly follow these rules, they find them valuable in determining appropriate short-term interest rates.