Fed talks tough -- and hopes that's all it has to do

Repeat something enough and people might actually begin to believe it's true.

So it went this week with Federal Reserve Chairman Ben S. Bernanke and his cohorts at the central bank.

They made clear that inflation is their primary worry at the moment, and that they're ready to raise interest rates if that's what it takes to subdue price pressures.

Raise interest rates? Could this be the same Fed that slashed its key short-term rate from 4.25% to 2% between January and April in a drastic attempt to keep the financial system from melting down?

Mission accomplished?

The turnabout in the Fed's tone has been building for weeks, but Bernanke, nicknamed Gentle Ben, on Monday issued a warning that was as tough-sounding as he could muster.

The continuing surge in energy prices "has added to the upside risks to inflation and inflation expectations," he said in a speech. The Fed, he added, "will strongly resist an erosion of longer-term inflation expectations."

"Strongly resist" could mean only one thing: a rate hike.

The Fed's Philadelphia bank president, Charles Plosser, was more direct. He told CNBC on Thursday that the Fed would have to "act preemptively" to damp inflation.

Central bank officials now have talked enough about a possible credit-tightening move that bond investors, at least, believe them.

Consider: A week ago the annualized yield on two-year Treasury notes was 2.38%, not much above the Fed's benchmark rate of 2%.

By the close of trading on Friday, the two-year T-note yield was 3.02%, a stunning jump of 0.64 of a percentage point in five trading days.

Investors suddenly demanded higher yields to compensate for two risks: first, that the Fed would raise its own rate sooner rather than later, putting a higher floor under all interest rates; and second, that maybe inflation really was a bigger problem than the bond market had assumed.

For bond owners, inflation is Public Enemy No. 1 because it erodes their fixed-rate returns over time.

On Friday, the government's report on May consumer inflation was ostensibly good news. Although the overall consumer price index rose 0.6% last month, the so-called core index (excluding food and energy costs) was relatively tame, up 0.2%. That left the overall inflation rate at 4.2% over the last 12 months and the core rate at 2.3%.