Fed hopes words will do enough to contain prices

By Pedro Nicolaci da Costa

HARWICH, Massachusetts (Reuters) - The U.S. Federal Reserve is hoping tough talk on inflation will do the job of moderating recent price increases, giving it room to avoid raising interest rates as the economy remains fragile.

The problem is that investors may try to determine whether the central bank is bluffing.

A failure to deliver on its implicit promise of tighter monetary policy could lead to increased financial market volatility and derail the tentative calm that aggressive Fed action has managed to inspire.

Futures markets have already begun pricing in chances of an interest rate hike as early as September, a prospect that many analysts think is far-fetched given the still-shaky state of housing and finance.

"They are threatening at the moment but I don't think they'll really pull the trigger," said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi, who was speaking on the sidelines of a Fed conference on inflation on Cape Cod.

The about-face in Fed speak has come abruptly. Just a month ago, most officials seemed keenly focused on the risk that economic growth would slow even further, buried under the weight of falling home values and rising energy costs.

But in a series of recent speeches, Fed chief Ben Bernanke appears to have tilted the prevailing discourse toward the central bank's more hawkish camp.

On Monday, Bernanke said the Fed would work to restrain consumer expectations of higher prices. He also played down a May surge in the unemployment rate from 5 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.

"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 trouble, according to many investors, is that the Fed's hands are tied.

"Is there enough life left in the patient in the wake of the housing and credit bust and the oil shock that would allow the Fed to heap further stress on the host?" asks William O'Donnell, head of U.S. interest rate strategy at UBS Securities in Stamford Connecticut. "We think not and we think that words will have to suffice.

The weakness of the dollar is also a central issue for the Fed and is part of the reason the central bank has stepped up its rhetoric on inflation.

ROCK AND A HARD PLACE

The Fed is worried record-high energy costs could lead consumers to expect a swift inflation pace is here to stay, setting in motion a self-feeding wage-push inflation cycle.

Indeed, some data suggest inflation expectations are already on the rise. The Conference Board said its survey of consumers showed inflation expectations hit an all-time high of 7.7 percent last month.