The strong economy earlier this year has increased capacity utilization and tightened the labor market. Meanwhile,the weakness of the dollar means that the impact of global deflation is currently muted, says Keith Wade, chief economist at Schroders, based in London.
The pick-up in inflation will be a test of Bernanke’s credibility,Wade says,making it likely that the Fed will raise rates by a quarter point at both the June 29 and August 8 meetings, bringing the target federal funds rate up to 5.5%.
Some economists warn that if inflation continues to rise in the coming months,it could cause the Fed to persist in raising rates and to overshoot. "A reactive Fed runs the risk of tightening monetary policy too far" and then beginning to ease too late,” says Gabriel Stein,director and chief international economist at Lombard Street Research in London.Bernanke’s latest comments show that future Fed moves will be dependent on incoming data.If the price data show inflation over the past 12 months rising,the Fed runs the risk of over-tightening, Stein says. The Fed’s preferred inflation measure,the underlying personal consumption expenditure deflator, shows that inflation is contained.However, there is a close relationship between the core CPI and the PCE deflator, implying that the latter is likely to turn up in coming months, according to Stein.If so, Bernanke will be tested further.