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The data suggest sluggishness, but Federal Reserve chair Janet Yellen sees encouraging signs in U.S. economic growth and job creation.

JOSHUA ROBERTS/REUTERS

In its upward march on interest rates, the U.S. Federal Reserve has just slowed its cadence, if only subtly. And the reason is a fear that it will get tripped up by inflation. Or, more accurately, a confounding lack of inflation – which, for a 21st-century central bank, is a major obstacle indeed.

In its rate decision Wednesday, the Fed's policy-setting Federal Open Market Committee did go ahead with a widely expected quarter-point increase in its key rate, to a range of 1 to 1.25 per cent, the highest it has been since the global financial crisis hit in the fall of 2008. That's the third rate hike by the U.S. central bank in the past six months, as the Fed continues to gradually rebuild rates from the near-zero levels that presided over the postfinancial crisis economic recovery. It even announced that it would begin a very, very slow reduction of its balance sheet later this year, unwinding the trillions of dollars' worth of bonds it bought to prop up the U.S. economy and financial markets during and after the crisis.

That speaks to the Fed's conviction that the U.S. economy is on a healthy growth track, despite recent hiccups. In its rate-decision statement as well as in comments from Fed chair Janet Yellen in a press conference following the announcement, the bank didn't sound fazed at all that the U.S. economy grew at a paltry 1.2-per-cent annualized pace in the first quarter (it "appears to have rebounded" since, Ms. Yellen said), or that job creation has just gone through its slowest three-month stretch in nearly five years (the labour market is still strengthening, she assured).

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Read more: Fed raises rates, unveils cuts to bond holdings

But in the quarterly economic and interest-rate projections that accompanied the rate decision, the Fed blinked, just a little.

The median forecast of Federal Open Market Committee participants is still for one more rate hike before the end of this year, as it was in the previous outlook in March, but the high end of the range of forecasts has come down, and one-quarter of the participants now see no more rate hikes this year. One FOMC member (Minneapolis Fed president Neel Kashkari) even voted against the rate hike.

This despite slightly better median projections for economic growth outlook (2.2 per cent in 2017, up from 2.1 per cent in March) and unemployment (4.3 per cent this year, down from 4.5 per cent).

The potential stumbling block is inflation.

The median projection for personal consumption expenditure inflation (the Fed's preferred measure) retreated to 1.6 per cent this year, down from 1.9 per cent in the March forecasts. This came just hours after the release of new monthly data showing that consumer price index inflation dipped to 1.9 per cent year over year in May from 2.2 per cent in April, its third consecutive decline. The "core" inflation measure, which excludes the typically volatile food and energy components, weighed in at just 1.7 per cent, its fourth straight drop.

The Fed has two key mandates guiding its management of interest rates: To maximize employment, and to stabilize prices around a 2-per-cent inflation objective. With the U.S. unemployment rate sitting at a 16-year-low, that side of the job looks well in hand, and, indeed, provides a strong argument for higher rates to ease the job-creation throttle a little. Indeed, a tight labour market would normally go hand-in-hand with higher inflation, by putting upward pressure on wages and fuelling household consumption.

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But the inflation side of the equation has suddenly drifting further from reach. And the Fed signalled that this is becoming its chief preoccupation as it tries to chart its interest-rate course from here.

"At the moment, we are highly focused on trying to achieve our 2-per-cent objective," Ms. Yellen said. "It's essential for us to move inflation back to that objective."

The inflation mandate is hardly unique for a modern advanced-economy central bank; indeed, most of them around the world, Canada's included, have set price stability as the cornerstone of monetary policy for the better part of two decades. It has served them well as a proxy for pressures on economic capacity. Despite the contradictory signal that U.S. inflation is giving off, the Fed isn't about to slough off its inflation mandate.

Ms. Yellen believes that the recent slippage on the inflation front is a temporary blip, and that "conditions are in place for inflation to move up." Still, it sounds like the Fed is getting a little nervous about continuing to push rates higher until it's sure inflation is coming along for the compulsory ride.

Indeed, it now looks quite plausible that the Fed, which has stressed a "gradual" approach to rate increases all along, could take a break until the desired inflation trend starts to kick in. This wouldn't be out of character at all; remember that the Fed under Ms. Yellen took a full year between its first rate hike, in late 2015, and the follow-up at the end of last year. In the absence of an inflation turnaround, it's not out of the question that we have just seen our last Fed increase of 2017.

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