* Markets continue to expect rate increase at March meeting
* Policy decision draws curtain on Yellen era
* Fed upgrades inflation outlook
WASHINGTON, Jan 31 (Reuters) - The U.S. Federal Reserve kept interest rates unchanged on Wednesday but said inflation likely would rise this year, bolstering expectations borrowing costs will continue to climb under incoming central bank chief Jerome Powell.
Citing solid gains in employment, household spending and capital investment, the Fed said it expected the economy to expand at a moderate pace and the labor market to remain strong in 2018.
"Inflation on a 12-month basis is expected to move up this year and to stabilize" around the Fed's 2 percent target over the medium term, the central bank said in a statement following a two-day policy meeting, the last under Fed Chair Janet Yellen.
It also said its rate-setting committee had unanimously selected Powell to succeed Yellen, effective Feb. 3. Powell, a Fed governor who has worked closely with Yellen, was nominated by President Donald Trump and confirmed by the U.S. Senate.
Powell is expected to hew closely to the policies embraced by Yellen, who spearheaded the gradual move away from the near-zero interest rates adopted to nurse the economy back to health and spur job growth after the 2007-2009 recession.
Fed policymakers have been encouraged in recent months as the economy picked up speed and the unemployment rate fell to a 17-year low of 4.1 percent.
The Fed, which raised rates three times last year and in December forecast three more hikes for this year, said on Wednesday it expected "further gradual" rate increases will be warranted. The target range for the federal funds rate currently is 1.25 percent to 1.50 percent.
"The use of 'further' opens the door to four hikes and likely closes the door on two," Michael Gapen, chief U.S. economist for Barclays, wrote in a note to investors.
U.S. stocks rose slightly after the Fed statement before paring gains. Short-term interest rate futures showed traders adding slightly to bets the Fed would raise rates three times in 2018, starting at its next meeting in March.
INFLATION VIEW UPGRADED
The Fed's gradual path of rate increases will hinge on a continued pickup in inflation, which has lingered below target despite a strong job market. Fed policymakers have said they expect an acceleration this spring, once short-term factors that held down inflation are squarely in the rear-view mirror.
In its statement, the central bank noted that market-based measures of inflation have increased in recent months.
The statement did not address the likely impact of the Trump administration's tax overhaul on economic growth, and gave no hint of concern about overshooting on inflation.
Several Fed policymakers recently have said they expected the tax changes, which include an estimated $1.5 trillion in corporate and individual tax cuts, to provide an economic lift by boosting business and household spending.
The economy grew 2.3 percent in 2017.
U.S. stocks have soared to record highs in recent weeks as investors calculated that corporate profits would rise after the passage of Trump's tax legislation.
There were no dissents in the Fed's decision on Wednesday.
(Reporting by Ann Saphir and Jason Lange; Additional reporting by Sinead Carew and Richard Leong in New York and Noel Randewich in San Francisco; Editing by Paul Simao)