By Howard Schneider and Ann Saphir
WASHINGTON (Reuters) - The U.S. Federal Reserve kept interest rates unchanged on Thursday in a bow to worries about the global economy, financial market volatility and sluggish inflation at home, but left open the possibility of a modest policy tightening later this year.
In what amounted to a tactical retreat, Fed Chair Janet Yellen said in a press conference that developments in a tightly linked global economy had in effect forced the U.S. central bank's hand.
The U.S. economy has been performing well enough to perhaps justify a rate hike "and we expect it to continue to do so," Yellen said shortly after the Fed's policy-setting committee released its latest statement following a two-day meeting.
But Yellen added that "the outlook abroad appears to have become less certain," driving down U.S. equity prices, pushing up the dollar, and tightening financial conditions in a way that may slow U.S. growth regardless of what the Fed does.
"In light of the heightened uncertainty abroad ... the committee judged it appropriate to wait," Yellen said. "Given the significant economic and financial interconnections between the U.S. and the rest of the world, the situation abroad bears close watching."
The policy statement also nodded squarely to international events as a decisive variable within Yellen's "data-dependent" Fed.
"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," the statement said.
However, the Fed maintained its bias towards a rate hike sometime this year, while lowering its long-term outlook for the economy.
Fresh economic projections showed 13 of 17 Fed policymakers foresee raising rates at least once in 2015, down from 15 at the last meeting in June. Four policymakers now say rates should not be raised until at least 2016, compared to two who felt that way in June.
The Fed has policy meetings in October and December.
In deciding when to hike rates, the Fed repeated it wanted to see "some further improvement in the labor market," and be "reasonably confident" that inflation will increase.
The dollar fell against a basket of currencies after the release of the statement, trading about 1 percent lower against the euro. Stocks initially edged higher before turning lower in choppy trade, while prices for U.S. Treasuries rose.
Taken as a whole, the latest Fed projections of slower GDP growth, low unemployment and continuing low inflation suggest that concerns of a so-called secular stagnation may be taking root among policymakers. One policymaker even suggested a negative federal funds rate.
The median projection of the 17 policymakers showed the Fed expects the economy to grow 2.1 percent this year, slightly faster than previously thought. However, its forecasts for GDP growth in 2016 and 2017 were downgraded.
The Fed also forecast inflation would creep only slowly toward its 2 percent target even as unemployment dips lower than previously expected. It sees the unemployment rate hitting 4.8 percent next year and remaining at that level for as long as three years.
The Fed's projected interest rate path shifted downward, with the long-run federal funds rate now seen at 3.5 percent, compared to 3.75 percent at the last policy meeting.
"The Fed has become more dovish, with growth projections revised down amid rumblings of 'secular stagnation.' But there's a clear signal that, in the absence of any serious derailing of the economy, rates will rise before the year is out," said Chris Williamson of financial information services firm Markit.
The vote on the policy statement also was a sign of how China's economic slowdown and market slide left Fed officials unnerved about the state of the world economy. Only Richmond Fed President Jeffrey Lacker dissented.
Fed officials like board member Jerome Powell and Atlanta Fed President Dennis Lockhart in recent months had publicly endorsed a September rate hike, forming a near majority along with longstanding inflation hawks like Lacker.
In the end, however, they were left with a muddled picture marked by low U.S. unemployment and steady economic growth, but no sign that inflation has begun to rise towards the Fed's target.
(Reporting by Howard Schneider and David Chance; Editing by Paul Simao)