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WASHINGTON, Feb 26 (Reuters) - There are some upside risks to the U.S. economic outlook but the degree to which it would affect monetary policy depends on whether the potential capacity of the nation's economy is also raised, Federal Reserve Governor Randal Quarles said on Monday.
"There is a real possibility that some of the factors that have been holding back growth in recent years could shift," the Fed's newest board member said in remarks prepared for delivery to the National Association for Business Economics conference in Washington.
"It could mean a higher natural interest rate, which would increase the amount of accommodation provided at a given level of the Federal Reserve's policy interest rate," he said.
The natural rate is the level of borrowing costs associated with stable inflation and full employment. Assessing the long-run rate is key to Fed policymakers forecasting how high they should ultimately raise interest rates.
In a relatively bullish speech, Quarles said he was optimistic on the economy and that there were some upside risks to the U.S. economic outlook. He added in a question and answer session that there were signs the United States has a sustainably strong economy.
However, he also cautioned that any sustainable rise in the growth rate of the world's largest economy would depend on a diminishing of factors that have held back growth in recent years, such as weak business investment and productivity.
Quarles repeated that further gradual increases in interest rates would be appropriate, similar to the view he gave last week.
Quarles, a close ally of new Fed chief Jerome Powell, also said he expects the current shortfall in inflation to be transitory and for it to move back the 2 percent target rate "over the next year or so."
"I will be carefully watching indicators of economic activity and inflation and assessing the degree to which activity appears to be pushing up against the constraints of the economy," he said.
Quarles took up his position in October and until now has mainly focused his comments on banking supervision in his role as the Fed's point person on financial regulation.
The Fed's preferred measure of inflation has fallen short for nearly six years but recent data has shown signs of an uptick in pricing pressures.
On Friday, the Fed said it expected economic growth to remain steady and saw no serious risks on the horizon that might pause its planned pace of rate rises.
Investors have all but priced in another rate increase at the Fed's next meeting, on March 20-21. The central bank currently forecasts two more rate rises after that this year.
A boost from the Trump administration's $1.5 trillion in corporate and individual tax cuts passed late December has caused some policymakers to keep an open mind on whether the Fed may need to tighten more aggressively but they have also said it is too early to tell.
Quarles' remarks come one day before the Powell's keenly awaited semi-annual testimony to Congress after which the Fed chief will answer questions from lawmakers on the U.S. economy. (Reporting by Lindsay Dunsmuir; Editing by Chizu Nomiyama)