The U.S. Federal Reserve Board’s Federal Open Market Committee decided to keep interest rates at 5.25% at its meeting on Wednesday, as falling energy prices helped to ease inflationary pressures.

The decision to stand pat, which was highly anticipated, reflects the continuing moderation in economic growth, which is also partly reflected by the cooling of the U.S. housing market. The Fed also left rates unchanged at their last meeting in August, breaking a record string of 17 rates hikes dating back to June 2004.

“Readings on core inflation have been elevated, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand,” the Fed said in a news release.

Nevertheless, the FOMC stated that some inflation risks remain. As a result, the extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth.

All but one member of the FOMC voted to keep rates stead; the dissenter, Jeffrey Lacker, voted in favour of a 25-basis point increase.

Reading the tea leaves in today’s policy statement has economists expecting the Fed to remain on the sidelines this year and beginning to contemplate rate cuts next year.

TD Bank says the statement issued today was “just a smidgen more dovish than the August 8 missive – but less dovish than some in the market were expecting.” It notes that Richmond Fed president Jeffrey Lacker voted in favour of another rate hike at today’s meeting, as he did last time.

“Clearly, the Fed remains reluctant to remove its tightening bias, and understandably so. It will indeed need to see clear evidence that the inflation risks are dissipating before moving to a more neutral stance, and that will take some time,” TD says. “The last thing chairman Bernanke would want to do is re-ignite concerns that he is soft on inflation. Nonetheless, we remain convinced that the tightening cycle is over, and that it is only a matter of time before the Fed starts to sing a more dovish tune.”

“What could sway the Fed in adopting a neutral bias? Lower home prices or/and a deterioration in labour markets with stable energy prices,” comments National Bank Financial. “We are obviously not there yet. Pending unforeseen events, the Fed is likely to drag its feet a little longer and again maintain its tightening bias at its October 24-25 meeting. In all likelihood, the December 12 meeting will be the one where we might see a significant change of tone and the adoption of a neutral bias.”

BMO Nesbitt Burns agrees that the language in the press release was apparently a bit more bearish than the markets expected, as the initial reaction was a temporary selloff in bonds and a rise in the U.S. dollar.

“Instead of highlighting that inflation pressures have already moderated, as the market expected, the Fed continued to pose this as a future possibility rather than a done deal,” it notes. “As usual, there is a host of contradictory factors; but given that the most recent CPI and PPI numbers were milder than expected, and headline and core inflation has slowed, the Fed will likely continue to give the moderating-inflation story the benefit of the doubt.”

“Their reluctance to raise rates is also attributable to the shakiness of the auto industry (Ford, GM, Chrysler), housing, airlines, sub-prime loans, hedge funds (Amaranth Advisors), commodities (CRB down a near-record 14+%, biggest decline since 1974), emerging markets (Thailand, Hungary) and credit spreads. The Fed is well aware of their record of triggering financial crises,” BMO Nesbitt adds. “With this cover, the Bank of Canada is likely to stand pat, as well, when they announce again on October 17.”

“As the economy slows, the pressure on the inflation front will gradually dissipate. Not only will that lock in the Fed’s decision to remain on the sidelines, but will most likely set the stage for outright rate cuts in 2007,” concludes TD.