Gains in consumer spending, defense contracts and "a surge in net exports" in the final quarter of 2007 are "expected to prove largely transitory," the Fed report said.

Nonfarm payrolls increased "robustly" in December, the Fed said, with unemployment remaining steady at 4.5 percent.

But, gains in manufacturing in November and December weren't as strong as in previous years, the Fed reported.

Inflation was slowed by warmer temperatures that helped decrease energy consumption but residential construction remained "quite weak," the report said.

The Fed said economic growth would sputter forward at 1.3 to 2.0 percent for 2008 and raised its inflation index 0.3 percent for both core and non-core goods.

Investors saw the Fed's remarks on inflation as indication that another federal fund rate cut was possible.

The report indicates the Fed's willingness to adjust the rate down or up. The current rate, at 3 percent, "appeared appropriate for a time," the Fed said. But, "when prospects for growth had improved, a reversal, possibly even a rapid reversal, might be appropriate," the report said.