Fed May Hold Rates Steady Despite Inflation: Kohn

Federal Reserve Vice Chairman Donald Kohn hinted that the central bank is inclined to leave rates steady despite rising inflation worries among US consumers.

In prepared remarks to the Boston Fed"s inflation conference on Cape Cod, Kohn said that when the economy is hit with an oil price shock as it has been this year, the "appropriate" Fed policy will permit -- temporarily -- both higher inflation and higher unemployment.

CNBC.com Donald L. Kohn

"It may be efficient to allow some adjustment period in which both overall inflation exceeds its desired low level and the unemployment rate is higher than its long-run sustainable level," Kohn said.

Even so, rising inflation expectations are beginning to worry the Fed. Repeated increases in energy prices "have contributed to a rise in the year-ahead inflation expectations of households" this year, Kohn said.

"Any tendency for these longer-term inflation expectations to drift higher or or even fail to reverse over time would have troublesome implications for the outlook for inflation," he warned.

Kohn became the latest Fed official in recent days to talk about energy prices pushing up inflation worries.

On Monday,Fed Chairman Ben Bernanke said the centeral bank 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 Fed 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.

"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 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.

Now that the average price of a gallon of gasoline has hit a record above $4 a gallon, expectations could climb further.

Still, many economists say a wage-price cycle is unlikely to develop, given the weak state of the economy. Over the past year, the rise in average hourly earnings has slowed.

At the same time, the swooning housing market has shown few signs of life. Home prices have fallen 14 percent over the past year by one measure, cutting many homeowners off from the equity they had tapped for spending during the housing boom.

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