With the U.S. economy creating jobs at a steady pace, the Federal Reserve will need several months of softer price gains and evidence wages are not picking up before its anxiety about inflation subsides.
U.S. non-farm employers added 132,000 workers to their payrolls in June and job growth in April and May was stronger than first thought, the government said Friday in a report that showed the jobless rate holding at a low 4.5 percent.
With the economy rebounding after a weak first quarter, Fed policy-makers will want to see inflation excluding energy and food stay below 2 percent for several months in row.
The interest-rate setting Federal Open Market Committee will also want to be sure that higher prices for food and energy, particularly gasoline, are not bleeding into prices for other goods and services.
That translates to a Fed holding benchmark overnight interest rates steady at 5.25 percent for several more months at least, looking for inflation to ebb.
"I suspect the Fed's on hold for the rest of the year and (Fed Chairman Ben) Bernanke's going to be talking about inflation," said John Silvia, chief economist for Wachovia in Charlotte, North Carolina.
Bernanke is scheduled to give a speech on inflation Tuesday, and is expected to deliver semiannual monetary policy testimony on Capitol Hill July 18 and 19. Financial markets will look to those appearances for clues on whether the Fed's inflation angst is starting to ease.
IMPROVED CORE INFLATION
The U.S. central bank has held its target for overnight rates steady for over one year, and has been patiently waiting for sluggish growth to help curb price pressures.
Tepid growth in the first quarter had led financial markets earlier this year to bet the Fed could lower rates before year-end from what analysts and officials consider a slightly restrictive policy stance.
But the Fed has persistently said its predominant worry is that inflation would not ease, and it has pointed to a tight labor market as a potential trigger for inflation.
However, Friday's employment report suggested wage pressures, while somewhat elevated, were holding steady.
Average hourly earnings ticked down to a a 3.9 percent gain in June from a year earlier, in a range it has held for a year.
At the same time, while economic growth is now picking up, core inflation has edged lower and many have begun to wonder whether the Fed would stop signaling that it may still need to raise interest rates.
But when Fed policy-makers announced a decision to hold rates steady on June 28, they said a lasting easing of inflation pressures remained in doubt.
Harm Bandholz, an economist for UniCredit Markets and Investment Banking in New York, wrote in a note to clients that a fairly steady reading on average hourly earnings understates the upward cost pressure wages are exerting.
"With an unemployment rate that is still substantially lower that the natural unemployment rate, labor cost inflation will continue to accelerate," Bandholz said.
ENERGY, FOOD PRICE RISES
In addition to concerns about a tight labor market, the Fed may also be worried by the sharp gains in food and energy costs that have pushed overall consumer prices higher.
In May, the U.S. consumer price index rose 0.7 percent, the steepest climb in 1-1/2 years.
Energy prices gained for a fourth straight month, with gasoline prices up 10.5 percent. Food prices have risen at a 6.2 percent annual rate so far in 2007, nearly three times the 2.1 percent increase for all of 2006.
"If you had a stabilization in food and energy prices that brought down the headline numbers ... and you still had an economy that was growing at only a trend pace, or maybe a little less, in that case they'd probably be more satisfied," said Jan Hatzius, chief U.S. economist for Goldman Sachs in New York.