(Adds analyst, Yellen comments, updates markets)
* Balance sheet to fall up to $10 billion per month at first
* Fed still anticipates December interest rate hike
WASHINGTON, Sept 20 (Reuters) - The U.S. Federal Reserve left interest rates unchanged on Wednesday but signaled it still expects one more increase by the end of the year despite a recent bout of weak inflation.
New economic projections released after the Fed's two-day policy meeting showed 11 of 16 officials see the "appropriate" level for the federal funds rate, the central bank's benchmark interest rate, to be in a range between 1.25 percent and 1.50 percent by the end of 2017.
That is one-quarter of a point above the current level.
Financial markets barely moved after the release of the statement and projections. There also was little reaction to the Fed's announcement that it would begin decreasing its balance sheet next month, perhaps confirming its hope that the portfolio runoff would be as exciting as "watching paint dry."
"The Fed did a good job telegraphing what they were going to do and then they followed through with it, so I'm not sure the market (had) all that much of a reaction to it," said Michael Arone, chief investment strategist with State Street Global Advisors in Boston.
In its policy statement, the Fed cited strength in the job market, growth in business investment and an economic expansion that has been moderate but durable this year. It added that the near-term risks to the economic outlook remained "roughly balanced" but said it was "closely" watching inflation.
Fed Chair Janet Yellen said in a press conference after the end of the meeting that the fall in inflation this year remained a mystery, adding that the central bank was ready to change the interest rate outlook if needed.
"What we need to figure out is whether the factors that have lowered inflation are likely to prove persistent," she said. If they do, "it would require an alteration of monetary policy," Yellen said.
While the interest rate outlook for next year remained largely unchanged in the Fed's latest projections, with three hikes envisioned in 2018, the U.S. central bank did slow the pace of anticipated monetary tightening from there.
It forecasts only two increases in 2019 and one in 2020. It also lowered again its estimated long-term "neutral" interest rate from 3.0 percent to 2.75 percent, reflecting concerns about overall economic vitality.
The Fed, as expected, also said it would begin in October to reduce its approximately $4.2 trillion in holdings of U.S. Treasury bonds and mortgage-backed securities by initially cutting up to $10 billion each month from the amount of maturing securities it reinvests.
That action will start a gradual reversal of the three rounds of quantitative easing the Fed pursued between 2008 and 2014 to stimulate the economy after the 2007-2009 financial crisis and recession.
The limit on reinvestment is scheduled to increase by $10 billion every three months to a maximum of $50 billion per month until the central bank's overall balance sheet falls by perhaps $1 trillion or more in the coming years.
Yellen said it would take a "a material deterioration" in the economy's performance for the Fed to reverse a schedule she expects to proceed "gradually and predictably."
The U.S. dollar rose against a basket of currencies after the release of the Fed's policy statement. U.S. stocks extended losses while yields on U.S. Treasuries rose slightly.
The policy statement and accompanying projections showed the Fed still in the middle of a balancing act between an economic recovery that has kept U.S. unemployment low and is gaining steam globally and a recent worrying drop in U.S. inflation.
Three of the hawkish policymakers appeared to move their expected policy rate down to account for only one more hike by the end of 2017, leaving a core 11 clustered around a likely December increase. The Fed has raised rates twice this year.
The Fed noted that the recent hurricanes in the United States would affect economic activity but are "unlikely to materially alter the course of the national economy over the medium term."
Forecasts for economic growth and unemployment into 2018 and beyond were largely unchanged. Gross domestic product is now expected to grow at a rate of 2.4 percent this year, 2.1 percent next year and 2.0 percent in 2019.
The unemployment rate is forecast to remain at 4.3 percent this year before falling to 4.1 percent next year and remaining there in 2019.
Inflation is expected to remain under the Fed's 2 percent target through 2018 before hitting it in 2019.
There were no dissents in the Fed's policy decision.
(Reporting by Howard Schneider and Ann Saphir; Editing by David Chance and Paul Simao)