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Fears that the

Federal Reserve

has fallen "behind the curve" on inflation seem to be, well, inflated.

After a couple of worrying reports on consumer and wholesale prices and some solid jobs data, investors have grown increasingly concerned that the Fed has waited too long to raise interest rates and that the economy is in danger of overheating. The producer and consumer price indices for April, which are due out this week, could fan those flames.

Yet core inflation, which excludes food and energy prices (which are volatile), continues to be held down by overcapacity and strong productivity. The Fed's preferred measure of inflation, the core personal consumption expenditure index, is running at 1.4% year over year, the same trend that prevailed a year ago when it was fear of deflation that loomed largest.

If the Fed were to raise rates in the near term, it would be the first time in 40 years that it did so when the year-over-year trend in core inflation was below 2%.

"The analytics of ample slack in both product and labor markets, while narrowing, and evidence of low inflation expectations, point only to a gradual rise in underlying inflation," said Morgan Stanley economist Richard Berner.

He noted that the output gap, or the difference between actual and potential GDP, remains at 1.3% of gross domestic product and could well be larger. Overcapacity and overproduction continue to weigh on a number of industries, leaving them with little pricing power. In addition, the University of Michigan's consumer survey suggests that five- to 10-year median inflation expectations are at 2.5%, a 25-year low.

Inflation expectations are important because they can become a self-fulfilling prophecy. If consumers expect prices to rise sharply in the future, they're likely to buy goods today rather than wait. This creates more demand, which sends prices higher.

Alan Blinder, a professor of economics at Princeton University and former vice chairman of the Federal Reserve, said no one will really know if the Fed has fallen behind the curve until a year from now. But he isn't overly concerned about it.

The danger of inflation spiking higher is "relatively remote," he said, adding that while prices will rise this year, they will do so from a very low, "aberrant" level.

Diane Swonk, chief economist at Bank One, said inflation has been driven up recently by a lot of transitory factors, not by fundamental factors such as accelerating wages. In the first quarter, unit labor costs fell 1.3% year over year.

Some economists expect labor costs to rise later this year as productivity weakens and businesses hire new workers. Unit labor costs rose at an annual pace of 0.5% in April, above expectations for a flat reading, and pundits are predicting bigger increases as the year progresses.

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Swonk said she expects interest rates to move up to 1.5% by the end of the year from 1% today, as the Fed reacts to signs of higher inflation. Fed funds futures contracts are pricing in 100 basis points of tightening.

Peter Kretzmer, senior economist at Banc of America Securities, said the central bank realizes that the economy is at a turning point, and he doesn't believe it will waste any time in raising interest rates.

"The Fed has leaned strongly toward ensuring that the recovery is sustainable before they tighten, and there are certainly some risks that there are more pressures in the pipeline now than they intended, we really don't know," he said. "But one thing is not arguable and that is that inflation was essentially zero last year and that gave

the Fed more flexibility than in the past."

Although many economists believe inflation will be tame going forward, the bond market is clearly worried that price pressures are building. The yield gap between the federal funds rate and the three-year Treasury is currently 205 basis points, while the difference relative to the 10-year note is 376 basis points. Since 1990, the funds rate has had an average spread of just 125 basis points relative to the three-year and just 162 basis points relative to the 10-year.

Investors sell bonds when they think prices are ramping up because inflation eats away at the value of interest payments. This selling sends yields higher, which can ultimately cool down the economy.

Jim Bianco, president of Bianco Research, said the bond market is focusing on the core consumer price index, which rose at a 3% annualized pace in the first quarter, as well as "booming" commodity prices and oil at $40 a barrel.

In a

Wall Street Journal

article Tuesday, Dallas Fed President Robert McTeer argued that oil prices, in inflation-adjusted dollars, aren't nearly as high as they had been during previous energy crises. Meanwhile, Philadelphia Fed Bank President Anthony Santomero said inflation is "low and stable," and Chicago Fed President Michael Moskow said the Fed has "yet to see the kinds of pressure on labor and capital resources that would foreshadow a worrisome increase in inflation."

To some extent, it doesn't matter whether bond investors are right or wrong about inflation because they've already determined it's a problem and are in a powerful position to influence Fed decisions.

Whether or not concerns about inflation have been exaggerated, apprehension about Fed policy is natural given that the Fed is moving into uncharted territory. Instead of trying to achieve price stability, the Fed must now attempt to maintain it.

"For most of our professional lives, the Fed has been fighting a war against inflation, called opportunistic disflation, fought with pre-emptive tightening and reactive easing," said Pimco managing director Paul McCulley in a recent speech. "That war is over, because we won it. Now the Fed is waging a campaign to win the peace of price stability, in a world in which inflation is two-sided, from a starting point too close to deflation."

"We have no data in our lifetime for the type of campaign that the Fed is now waging," he added.