Dilemma for Fed chief: How high to raise interest rates before they slow economy

WASHINGTON -- Four months into the job and the honeymoon is over for Federal Reserve Chairman Ben Bernanke. The stock market is gyrating. Inflation is picking up. Economic growth is slowing down.

It's an unsettling picture for Alan Greenspan's successor.

Bernanke has made clear that his biggest concern at the moment is making sure inflation does not spread through the economy. The main remedy is raising interest rates.

Yet that also is Bernanke's dilemma: How high can raise rates go before they slow an economy that already is showing signs of lethargy?

"In the eyes of many, Bernanke will truly earn his stripes as Greenspan's successor if he can tame inflation and avoid a recession," said Greg McBride, senior financial analyst at Bankrate.com.

Market shift

When Bernanke took over the Fed on Feb. 1, the economy was motoring ahead. Inflation, outside a burst in energy prices, was fairly well behaved. The Dow Jones industrials average was drifting upward, breaking the 11,000-mark in the middle of February; by early May, an all-time high was in reach.

Then the market skidded in early June, spooked by Bernanke's tough talk on inflation and the specter of higher interest rates.

Bernanke is a respected economist who spent most of his professional life in academia. Greenspan was a seasoned economic consultant who gained near legendary status as the central bank's chairman for 18 1/2 years and evolved into a cultural figure during his tenure.

In a surprisingly candid speech on June 5, Bernanke made clear that he would do all he could to tame inflation. Fed watchers say Bernanke's tough words were intended to bolster his inflation-fighting image.

Rising inflation barometers, Bernanke said, "are unwelcome developments."

Consumer prices for the first five months of this year are bounding ahead at a 5.2 percent annual rate, compared with the 3.4 percent increase for all of 2005.

Bump in interest rates

Prices -- excluding food and energy -- are advancing at a 3.1 percent pace this year; it was 2.2 percent last year.

For Bernanke and his predecessors, it is not just the inflation numbers that are so crucial. So, too, is the inflation mind-set of investors, businesses and consumers. If they believe prices will keep climbing in the future, it can affect behavior.

For instance, if workers think inflation will be higher a year from now, they are more likely to push for pay raises now. If businesses think costs will rise in the future, they may be more inclined to increase prices.

That means another bump in interest rates at the Fed's next meeting, June 28-29, to 5.25 percent, economists predict. Further increases could be in store depending on how inflation and economic activity unfolds.

President Bush, coping with low job-approval ratings, expressed confidence in Bernanke.

"Obviously, the Fed is watching the signals for inflation very carefully," he said.

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