The resurgence in pricing power in the US economy has caused a steady, but modest increase in core inflation over the last few months that leaves little doubt that the Federal Reserve will abandon its accommodative monetary policy and raise interest rates at their meeting on June 30.

An increase of 25 basis points is fully discounted in the futures markets, with a 20 percent probability that the US central bank will raise interest rates 50 basis points to 1.50 percent at the end of the month.

It has been a year since the Federal Reserve eased monetary policy for the 13th and last time, whereby US interest rates fell from 6.5 percent in summer of 2000 to a 45-year low of one percent last June.

Historically, tightening cycles tend to be shorter, typically lasting a year or so.

Recalling 1994 however, when US interest rates climbed from three percent to six percent over the space of 12 months, nervous investors are once again fretting over how much rates will have to rise to this time to effectively choke off resurgent inflationary pressures.

The rate which monetary policy will be adjusted is a real risk that must be considered.

Fed officials have already warned that the possibility of an aggressive tightening cycle exists, although core inflation remains very well contained for now.

Not surprisingly, Fed officials still largely maintain that “measured” steps will more likely be needed in this cycle, indicating that monetary policy is to be tightened gradually. This however has done little to assure the financial markets, where the probability of another 50 basis points increase in August increased to 35 percent over the last couple of weeks.

While most Wall Street economists surveyed in a recent Bloomberg poll expected US interest rates would be at two percent by year's end, the markets have already discounted they could be another 50 basis points higher than that.

In another indication of just how nervous the financial markets are, the jittery bond market is well on course to post its biggest quarterly loss in over 20 years.

Bond yields continued to climb last week. The stock market has performed better.

It usually does in the lead up to a tightening cycle, but if US interest rates are indeed set to rise by over 300 basis points next year as some are predicting, it is difficult to see how that can continue.

The bad news is that there is no doubt that the party is over.

The cost of money is going up, but while it may be time to take the punch bowl away, a gradual return to a more neutral position in interest rates of three percent still seems likely, assuming of course that inflation only rises to the still relatively benign level of two percent.

Such an adjustment would actually help achieve the longer-term goal of sustainable economic growth.

Historically, a neutral interest rate policy usually equates to a real return of one percent over the inflation rate.

Right now, US interest rates are actually lower than inflation, thus yielding a negative real return.

The solid return to profitability has finally emboldened corporations to increase payrolls in earnest and the troublesome slack in the US economy is being taken up.

Yet, while cheap money has raised a worrying amount of debt on US household's balance sheets, there are scant signs the economy is overheating.

The inflationary bogeyman this time around seems to be higher oil prices. This is best highlighted by the fact that the prices on the US Treasury's inflation linked bonds have recently virtually shadowed the movements in the price of oil.

From the perspective of inflation however, the evidence shows that higher oil prices do not always necessarily directly translate into higher consumer prices. What it does do however is behave like a brake on consumer demand, because higher fuel costs acts like a tax on disposable income. Yes, corporations are finding it easier to pass on costs to consumers, but Merrill Lynch's Chief North American economist, David Rosenberg, in a recent article examining the furore over high oil prices and inflation, makes a couple of critical observations here.

To begin with, the US economy's vulnerability to oil shocks has actually fallen considerably over the last 35 years, basically because of the decline in its manufacturing base.

A spike in oil prices would therefore not necessarily translate into significantly higher inflation.

Mr. Rosenberg also points out that the fears of supply may also be exaggerated given that long positions by non-commercial players are at unprecedented, historical highs.

In other words speculators, such as hedge funds, are betting huge that geo-political risks and growing demand from the emerging market economies, will mean that oil prices will continue to rise.

Not enough reason alone to start worrying about runaway inflation.

Kees van Beelen is a portfolio manager and a member of the Bank of Bermuda's Investment Policy Committee. The views expressed here are his and not necessarily the Bank's.