Sharpened Fed rhetoric lays rate-hike groundwork

WASHINGTON (Reuters) - Just six weeks ago the U.S. Federal Reserve was in interest rate-cutting mode. Now, Fed officials have hauled out rhetoric that suggests rates could rise within a few months.

The U.S. central bank's sudden shift to more aggressive anti-inflation language reflects both an easing of worries on financial market conditions and concerns over signs that inflation expectations are escalating.

Fed Chairman Ben Bernanke staked out the new position last week with an eye-catching defense of the downtrodden U.S. dollar.

This week, Bernanke, Vice Chairman Donald Kohn and St. Louis Federal Reserve Bank President James Bullard were among officials who said they were watching for any sign a self-feeding inflationary psychology could take hold.

"The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations," Bernanke said. "The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations."

While some Fed officials have been sounding the alarm about higher inflation for months, the harsher tone from Bernanke and Kohn marks an important shift away from an emphasis on the risk that financial turmoil, tighter credit and a deep housing contraction could tip the economy into a deep recession.

On April 30, the central bank lowered benchmark borrowing costs by a quarter-percentage point to 2 percent, the seventh reduction in a series dating to mid-September that has taken rates down by a cumulative 3.25 points.

Not all those reductions, however, were unanimous. Dallas Federal Reserve President Richard Fisher dissented at each of the Fed's last three meetings, and he was joined in opposition at the last two by Philadelphia Fed chief Charles Plosser.

GROUNDWORK FOR TIGHTENING

While the Fed is expected to hold rates steady at its upcoming meeting on June 24-25, financial markets now expect policy-makers to raise rates as soon as their subsequent meeting on August 5. A signal of their intentions could come when they announce their next decision.

"I don't think they're going to hike in June, but I think they're going to lay some of the groundwork that could be the precursor to rate hikes," said Wells Fargo economist Scott Anderson.

The course correction comes as markets show signs that the risks of a major destabilizing event, like the narrowly averted bankruptcy of investment bank Bear Stearns in March, have receded, even while some strains persist.

"I think Fed policy for the last 10 months has been focused on financial market turmoil and that has been a paramount concern," Bullard told reporters on Wednesday.

"And now that that turmoil is waning, it is natural for the Fed to turn back toward its mission of keeping inflation low and stable over the rest of the year," he said.

More broadly, the U.S. economy looks like it may skirt the recession many had forecast, buying the Fed room to protect the economy from a different threat -- inflation.

"The Fed has always stressed its risk-management approach," UniCredit economist Harm Bandholz said. "They said, 'We see the risk that we'll slide into deep recession, and in order to fight that risk, we'll slash interest rates.' Now they see it's not as bad as feared."

OIL PRICES

Bernanke and Kohn also had to come to terms with the effects of sharply higher oil prices, which have risen by roughly 40 percent since the start of this year and hit a record high above $139 a barrel last week.

Both officials -- and others at the Fed -- have said the central bank should not respond to oil price shocks by raising rates. But Bernanke this week acknowledged that relentless oil price gains risk fueling an inflationary mind-set that could make it easier for businesses to raise prices.

"The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations," he said.

Since forecasts that energy prices would moderate have not panned out, the officials may have felt compelled to address the issue, said Wells Fargo's Anderson.

"Oil prices haven't buckled under a weaker growth environment, so I think there's a sense that we need to start paying attention (to inflation)," he said.

A big jump in the cost of gasoline has led consumers to expect a higher level of inflation down the road. The Reuters/University of Michigan survey of consumers for May showed one-year inflation expectations surging to 5.2 percent, the highest since February 1982.

"The Fed has to make a leap of faith: is this a temporary thing that will reverse shortly, or is this the beginning of the inflation bug getting out of the box?," Deutsche Bank economist Carl Riccadonna said.

Riccadonna said the Fed may have felt it needed to talk tougher on inflation to try to rein in these expectations before they became entrenched.

Then there's the dollar. Bernanke broke the mold by expressing concerns on its value, a topic usually left to the Treasury secretary, just days before the European Central Bank said it might raise rates at its next meeting.

"If the Fed wants to maintain some floor for the dollar, it's really going to be difficult to do that if the ECB is raising rates and the Fed is standing pat," Riccadonna said.

(Reporting by Mark Felsenthal; Editing by Dan Grebler)