The U.S. Federal Reserve's recent tough talk on inflation served notice to financial markets that the central bank was serious about tamping down price pressures, but it has hit the economy in one of its tenderest spots -- housing.
Markets took immediate heed of surprisingly strong comments delivered by Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn on inflation earlier this month and began to judge chances of a rate hike at the Fed's August meeting a near certainty.
But a side effect of this new respect for the central bank's commitment to price stability came in the form of elevated longer-term interest rates, which reflects a steeper than previously expected march up in the overnight borrowing costs that the Fed controls.
These higher long-term rates on Treasury securities have quickly translated to higher rates for fixed-rate mortgages, a drop in mortgage applications and a slide in home loan refinancing that could push the prospect of a strengthening in anemic economic conditions further into the future.
"The Fed's tougher line on inflation has had some benefits in terms of the firmer dollar, and has taken some of the steam out of commodity prices," said Mark Zandi, chief economist for Moody's Economy.com. "But it also has created some problems, the most obvious being...another hit to the already fragile housing market."
The Fed may have been taken aback by the degree to which markets built in chances of rate hikes after Bernanke promised to "strongly resist" a rise in inflation expectations and Kohn said a rise in anticipated price increases over the longer term would be "troublesome."
In a sign the Fed may worry it overplayed its hand, anonymous senior officials and sources close to Bernanke were cited in newspaper reports this week as saying markets may have overreacted to hawkish Fed rhetoric.
The Fed would respond aggressively if inflation expectations spiked, but some Fed officials believe rates should hold steady if those elevated expectations do not materialize, the Financial Times said in one report.
The apparent efforts by the Fed to fine-tune its message came just shortly before its June 24-25 policy-setting meeting.
While the Fed is widely expected to hold interest rates steady next week, it may signal that its concerns have begun to move away from risks to growth and toward the risk of inflation.
In doing so, the Fed faces a delicate balancing act and the difficult task of offering a clear signal to financial markets as it tries to both tamp down inflation risks and nurse the economy back to health at a time oil prices have hit a record high near $140 a barrel.
"It is hard to talk down inflation expectations without talking up real interest rates," former Fed Governor Laurence Meyer and former Fed researcher Brian Sack of Macroeconomic Advisers said in a research note.
Expectations of higher rates could shave a quarter-percentage point off U.S. gross domestic product over the next four quarters, they said.
"The (Fed), of course, was well aware of this risk and felt it was outweighed by the benefit of capping inflation expectations," Meyer and Sack wrote.
Housing is at the heart of woes afflicting the sluggish economy. In each of the last two quarters, home building has fallen at an annual rate of more than 25 percent.
Reflecting rising worries about inflation, the yield on benchmark 10-year Treasury note leaped to a peak near 4.29 percent on June 13 from around 3.90 percent two weeks ago.
Since last Friday, the 10-year Treasury's yield has settled back to about 4.20 percent.
A report on Wednesday showed rates for 30-year fixed rate mortgages -- which closely track the 10-year Treasury -- averaged 6.57 percent in the week ended June 13, up 33 basis points and the highest since July 2007.
Mortgage applications dropped for the fourth week in the last five on higher rates, the Mortgage Bankers Association said.
But despite the moderation of its message, the Fed is signaling that now that the worst of the financial market crisis appears to be over, it would tolerate sluggish growth to wring inflation from the system.
"At the end of the day, if inflation expectations start to rise, they're going to tighten," Zandi said. "They have that credibility, and that's what everyone believes they're going to do."