Bernanke watchful of inflation risks from energy

By Pedro Nicolaci da Costa and Mark Felsenthal

HARWICK, Mass (Reuters) - Federal Reserve Chairman Ben Bernanke on Monday signaled the central bank would act to strongly resist rising inflation, as energy costs soar into the stratosphere.

Bernanke also played down a May surge in the unemployment rate from 5.1 percent to 5.5 percent, the biggest jump in 22 years, saying the risks of a substantial downturn in the U.S. economy had receded.

His remarks suggest inflation is featuring more prominently on the Fed's radar screen, indicating policy-makers have little intention to cut interest rates further. Average gasoline prices in the United States have just surpassed $4 a gallon for the first time.

"The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations," Bernanke said at a conference organized by the Boston Federal Reserve.

"The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation," Bernanke said.

The dollar jumped to a three-month high against the yen and U.S. Treasuries tumbled after Bernanke's remarks.

LEANING TOWARD THE HAWKS

Bernanke's inflation warning, the third in just one week, seemed to bring him closer to the more inflation-leery faction of the policy-setting Federal Open Market Committee, led by the presidents of the Dallas and Philadelphia Federal Reserve Banks, Richard Fisher and Charles Plosser.

Fisher told CNBC on Monday that a weak dollar could lead to a vicious cycle of higher inflation and weaker growth.

Still, analysts have been skeptical that tough talk on price growth would be followed up with real action in the form of higher interest rates.

Rate futures have begun pricing in the prospect of a rate hike as early as October, but some are skeptical as to whether the Fed's warnings on the dollar and inflation have any teeth, particularly at time when banks continue to reel from bad investments in the mortgage sector.

ROSIER ON GROWTH

For his part, Bernanke appeared relatively sanguine about the economic outlook, more so than he had been just a couple of months back.

"Although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so," he said

The speech also pointed to rising nervousness at the Fed over recent surges in oil prices, which have pushed crude oil reached a record over $139 a barrel last week.