As inflation climbs, all eyes on Yellen

Federal Reserve chief Janet Yellen faces a conundrum: Should she continue to press the accelerator or tap the brake on an economy that seems to be simultaneously spinning its wheels and gaining speed?

That's a question Yellen is likely to face today when she addresses reporters following the Fed's latest update on the U.S. economy.

Arguing in favor of keeping her foot on the pedal is the sluggish economic growth in the first half of the year and modest wage increases inhibiting a stronger recovery. But other signals could encourage the Fed to raise short-term interest rates earlier than expected.

Perhaps most notably, inflation has risen for three straight months, including a sharp 0.4 percent increase in May, the biggest jump in prices since February of 2013.

Although inflation remains at a modest 2.1 percent annualized rate, near the 2 percent target the Fed considers healthy, consumers are feeling the effects of price increases for food, energy, health care, clothes and other items. The cost of gas rose 0.7 percent last month, according to the U.S. Labor Department, and experts say the rising unrest in Iraq is likely to push prices at the pump even higher.

Meanwhile, other signs also suggest the economy is heating up, including strong consumer demand for cars and business equipment, along with a pickup in hiring by small businesses.

Until recently, most forecasters assumed the Fed wouldn't tighten monetary policy until the first or second quarter of 2015. But the hike in inflation, coupled with a faster-than-forecast decline in the nation's jobless rate this year, could alter those expectations.

As these inflationary pressures build, "The chances that [the Fed] will raise interest rates before the middle of next year are increasing," said Paul Dales, senior economist with Capital Economics, in a client note ahead of the Federal Open Market Committee's latest policy statement.

Since the recession that followed the 2008 financial crisis, the central bank has sought to stimulate economic growth by keeping a lid on interest rates. But some Fed members say the time for such "easy money" policies is drawing to a close, and they warn that keeping interest rates too low could cause a surge in inflation.

Michael Hanson, senior U.S. economist with Bank of America Merrill Lynch, expects the Fed on Wednesday to acknowledge the recent hike in inflation, noting in particular the risks from rising oil prices. But he and other forecasters think the inflationary pressures are unlikely to alter the Fed's timing on when to raise rates.

That's because the Fed remains focused on reviving the job market, which has only recently shown signs of regaining momentum after cold weather in December and January slowed hiring. Any hints by the Fed today that it could move sooner to raise interest rates could undermine that progress, as businesses ratchet back hiring in anticipation of higher borrowing costs.

Some Fed officials also may downplay the recent increase in consumer prices because they focus on a different gauge of inflation -- so-called personal consumption expenditures -- rather than the CPI data released on Tuesday. These expenditures, which are compiled quarterly by the federal Bureau of Economic Analysis, rose an annnalized 1.6 percent in April, up from March but still below the Fed's 2 percent target.

If there's a key to the Fed's thinking, it's likely to be found in the first three paragraphs of the FOMC's policy statement, which will come out shortly before Yellen addresses the media. That's the section where Fed officials generally describe the state of the economy and indicate their outlook for monetary policy.