Inflation may not be running out of control, but it's hot enough that the Federal Reserve's campaign of interest-rate hikes may end later rather than sooner.
It's a difficult call. The prevailing expectation in financial markets, largely unchanged by new inflation numbers Wednesday, is that the Fed is nearly done with its current cycle of tightening monetary policy.
But minutes of the most recent Fed meeting, released this week, show that some policymakers remain concerned that inflation levels are above an acceptable level.
The core rate of inflation - a measure of price levels that excludes volatile food and energy costs - has generally hovered above the comfort zone of 2 percent during the past year. And the government's latest report, released Wednesday for the month of January, shows no end to that trend: Core inflation, measured over the most recent quarter, is running at a 2.4 percent annual pace.
Given that, the question is whether the Fed will raise short-term interest rates not only to 4.75 percent in March, as now expected, but also to 5 percent in May and perhaps higher after that.
"There's probably a slightly greater chance that they will go higher than 5 percent, than that they won't go to 5 percent," says Mark Vitner, an economist at Wachovia Corp. in Charlotte, N.C. "I certainly think that the core rate of inflation is going to pick up in the next few months."
The consumer price index rose 0.7 percent in January - a surge driven largely by energy costs. January's jump in core inflation was 0.2 percent.
The pickup in inflation comes at a sensitive time for the economy. After 14 successive interest-rate hikes by the Fed since mid-2004, the combination of rising interest rates and a cooling housing market could dampen the growth of consumer spending. So far consumers, long the driving force of the current economic expansion, have remained buoyant despite the Fed's rate hikes and surging energy costs during the past year.
Against this backdrop, the Fed's goal is a "perfect landing." That would mean its policy tames inflation pressures but doesn't cut economic growth below its potential of 3 percent or more per year.
If the Fed pushes borrowing costs up too far, the result could be a less robust expansion with fewer new jobs. But if the Fed isn't vigilant enough, the result could be a sustained rate of inflation that takes its own toll on the economy by eroding purchasing power, among other problems.
"Reading [the Fed] has been trivially easy over the past year and a half, compared to what's it's going to be," says Richard Berner, who tracks the US economy for Morgan Stanley in New York.
For his part, Mr. Berner says the bond market may be overly optimistic in believing that the Fed is nearly done with its tightening, and that it will be able to cut rates later in the year.
"The fundamentals do, in my view, point to somewhat higher inflation," he says.
This doesn't present a major risk to the economy, but it would mean that tight monetary policy persists until core inflation subsides below 2 percent.
Another Wall Street investment house, Bear Stearns, also sees a risk of inflation surprising on the "up" side. "Markets have been dominated by what we think is an incorrect expectation that the U.S. economy will slow, the Fed will be dovish, inflation is tame, and interest rates are peaking," Bear Stearns economists said in a report earlier this month.
Certainly US consumers haven't slowed down yet. Retail sales surged 2.3 percent in January after a 0.4 percent rise in December.
Moreover, a tightening labor market could fuel expectations of wage inflation. Such expectations, in turn, can make for a self-fulfilling prophecy, ratcheting up inflation and making the Fed's job harder.
While many economists see the job market tightening, some others point to low workforce participation rates as a sign of slack. References by Fed officials, including chairman Ben Bernanke, to concerns about "resource utilization" point especially to the labor market.
Some of Chairman Bernanke's colleagues view core inflation and inflation expectations as "higher than ... desirable," according to the newly released Fed minutes.
"Clearly they feel that they need to be vigilant," says Bank of America economist Peter Kretzmer in New York. That practice has paid off in recent years, he says, by holding inflation expectations down.
In fact, while the core rate of inflation is above where Fed officials prefer, he says what's remarkable is how stable the core rate has held despite last year's surge in oil prices. That's a sharp contrast to the 1970s, but not enough, so far, for the Fed to declare victory in its current efforts.