THE US Federal Reserve Board has taken world financial markets by surprise by deciding to leave American interest rates unchanged.

The decision, taken by the Fed's open markets committee after a meeting in Washington, initially sent US shares soaring, but later they reversed sharply due to inflation fears. Last night the Dow Jones index closed at 5,874.03, down 20.71 points, providing an uncertain backdrop for European markets opening this morning.

The decision, which had been keenly awaited on Wall Street, means that the key Fed funds rate remains unchanged at 5.25 per cent.

Last night this was being seen as a setback for anti-inflation hawks at the Fed who had made no secret of their desire to see rates move higher to choke off inflation. Internationally, it is further evidence of the continued environment of low inflation and low interest rates which has sent markets higher for much of the year.

However, with investors nervous about the heights to which international markets have climbed, it remains to be seen whether forecasts last night that the Dow Jones was now heading for new record highs will prove correct.

The failure to raise rates was a fillip for President Clinton who has been counting on a trouble free economy in the run up to November's presidential elections.

President Clinton's senior economic adviser, Ms Laura Tyson, had warned earlier yesterday that a rate increase now would clearly have some slowing effect on the economy".

"There is nothing in the labour market that would suggest higher inflation," she insisted.

Despite this, a majority of US analysts had expected the Fed to raise rates, particularly after a leaked report last week showing that eight of its 12 regional Fed bank presidents supported a move upwards.

However, inflationary evidence was mixed. The Federal Reserve, in a survey of regional economic trends released on September 11th, found evidence of tight labour markets but few concrete signs of inflation. In August, the overall consumer price index increased just 2.9 per cent on an annual basis, while the core rate excluding food and energy showed an annual rise of only 2.6 per cent.

Mr Philip Orlando, chief investment officer at Value Line Asset Management, said the decision to leave rates unchanged was fully justified, given the complete absence of inflation. But Mr Graham Tanka, president of Tanka Capital Management, said he was disappointed the Fed had not taken a golden opportunity to nudge rates on as a pre-emptive strike on inflation.

Shares on Wall Street went on a roller coaster ride after the Fed's announcement, with the Dow Jones Index reversing a 30 point fall to stand 24 points higher shortly after the announcement. It later lost all these gains, suggesting that investors are now divided on where the market goes next.

The US long bond, meanwhile, rose by nearly two thirds of a point, cutting the yield to just under 7 per cent.

At the start of trading Wall Street had been unnerved by a profits warning from the US telephones giant AT&T, which said its earnings in the second half of the year would be up to 10 per cent below market estimates.

Earlier the London markets had been buoyed by good economic news on the domestic front as dealers waited nervously for the outcome of the Fed meeting.

The sharp improvement in Britain's trade balance also gave the government a further boost while other figures showing better than expected growth earlier this year were seen by economists as effectively ruling out further cuts in interest rates.

The British statistics showed a balance of payments surplus of £457 million sterling between April and June, compared with City forecasts of a deficit of around £1 billion. In addition, a trade gap of £1.1 billion in the first quarter of the year was revised down to £800 million.

However, the Dublin market ended slightly lower in thin trading.