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Traders work on the floor of the New York Stock Exchange on Thursday. The Federal Reserve is keeping U.S. interest rates at record lows in the face of threats from a weak global economy, persistently low inflation and unstable financial markets.Richard Drew/The Associated Press

In the U.S. Federal Reserve march toward inevitable interest-rate increases, inflation (or, more precisely, the persistent lack thereof) was considered little more than a bump on a road paved by a rapidly improving economy and stellar job growth. But now, as the Fed stopped short of its long-anticipated rate liftoff, inflation looms as the biggest obstacle in its path.

In perhaps the most anticipated Fed policy decision in years, the U.S. central bank decided Thursday to keep its key federal funds rate target in a range of 0 to 0.25 per cent, where it has sat for nearly seven years during the long and slow U.S. economic recovery. While traders' bets in the bond market were tilted slightly toward a stand-pat decision, this was almost certainly the closest the Fed has come yet to pulling the long-awaited trigger on rate hikes – which, up until the financial-market turmoil of the summer, had looked like all but a foregone conclusion.

In a single sentence in the Fed's statement accompanying the decision, it made its rationale crystal clear: "Recent global economic and financial developments may restrain economic activity somewhat, and are likely to put further downward pressure on inflation in the near term."

Observers who were betting against a rate hike had consistently held up the summer's volatile markets, and the related stumbles in the Chinese and global economies, as justification for the Fed to delay launch. But most were focusing on the risk-and-uncertainty story, a desire for the Fed to take its time and gain some more visibility into how the turmoil might play out.

Those kinds of risks are hard to gauge, even for an organization as sophisticated as the Fed. What the Fed could definitely see is that the fallout from the troubled summer is a slower path for inflation. It's the forgotten side of the Fed's policy mandate, yet the one critical indicator that was already nowhere near where the Fed wants it, and may now be even more distant on the horizon.

The Fed has two key mandates: Maximum employment and price stability. In practice, that means an unemployment rate in the ballpark of 5 per cent with inflation of 2 per cent.

The booming U.S. job market has done its part, with the jobless rate dipping to 5.1 per cent in August. For many observers, seeing unemployment dip so low made a rate hike a no-brainer, as the Fed wouldn't want to let the labour market tighten so much that it triggered a rush of wage-driven inflation.

What inflation? It clocked in at a puny 0.2 per cent year-over-year last month. But until now, the Fed sounded utterly unconcerned. It has long insisted that the depressed inflation rate was a "transitory" blip resulting from the plunge in oil prices and the rise in the U.S. dollar, which has made imported goods much cheaper. It would eventually all come out in the wash, and inflation would head back to 2 per cent.

But much as the Bank of Canada has found its own quest to close Canada's output gap an elusive one, the goalposts perpetually moving further away, the Fed is now worried about the same thing for its inflation target. U.S. consumer price index inflation has been below 2 per cent for more than a year now. And Fed Chair Janet Yellen acknowledged in Thursday's postdecision press conference that it now will take "longer than previously anticipated" for the Fed to reach its 2-per-cent inflation objective.

The Fed's new economic outlook, released along with the rate decision, shows a significant downgrade in the Fed's inflation forecasts for this year, and a delay in reaching 2 per cent until 2018, from 2017 previously.

There's no question that this inflation worry has set back the Fed's rate-hiking path. The Fed's so-called "dot plot" of interest-rate expectations among the members of its policy-setting Federal Open Market Committee (FOMC) now shows that the majority of members only anticipate one quarter-percentage-point rate increase before the end of the year, down from two in its previous forecast in June. Their median rate outlook for 2016 and 2017 is now a quarter-point lower than it was previously.

Interestingly, the Fed's solution to this persistent inflation underperformance may be to allow its other key mandate, employment, to overperform to compensate. Ms. Yellen suggested in the press conference that the Fed would be okay letting the unemployment rate remain around 5 per cent, or even drift lower, to allow building wage pressures to make up for the drag from other factors that has been keeping the inflation target at bay.

"The overshooting [on employment] helps [inflation] get back sooner than it normally would," she argued.

To that end, she said she and her colleagues "want to take a little bit more time" to see even more labour market gains, to "bolster" their confidence that underlying inflation pressures are in place to offset the deep transitory headwinds.

How much time? That's hard to say. Most FOMC members still look set on a hike before the end of the year, and the Fed only has two meetings left – late October and mid-December. December seems like the more obvious choice, since that meeting will include the release of another quarterly outlook update and another press conference, while the October meeting will only produce the Fed's typically brief decision statement – hardly an adequate communications device for the first rate change in seven years.

However, Ms. Yellen told the news conference that the Fed has a plan in place to call a special media briefing in October should it decide to raise rates then – removing the key communications obstacle that argues against an October hike.

Nevertheless, As Ms. Yellen stressed again Thursday, the markets have been obsessing too much about the timing of the first rate hike; what really matters, she said, is "the entire path of interest rates." At very least, the renewed focus on inflation has made that path look longer than it did before, if only a bit.

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