The opinions expressed here are those of the author, a columnist for Reuters.

By Jamie McGeever

ORLANDO, Florida, July 15 (Reuters) - Federal Reserve Chair Kevin Warsh no doubt welcomed last month's surprise fall in U.S. inflation, but his breathing room on interest rates will be limited.

Figures on Tuesday showed price pressures cooled much more than expected in June, especially in the “core” consumer price index (CPI), which excludes food and energy. This prompted the biggest scaling back of Fed tightening expectations in interest rate futures markets since February.

That makes Fed Governor Christopher Waller's comments on Monday about the potential need for a hike sooner rather than later ring a little hollow, and many economists say the Fed may not move at all this year.

While this softer core CPI print offers cause for cautious optimism, one should be careful about putting too much stock in one month's numbers. Warsh himself said as much on Tuesday, telling U.S. lawmakers he would not "cherry-pick" the moment as a sign of progress.

"There might be some that look at this morning's data and say, 'Oh, mission accomplished, everything is swell.' That is not my view," Warsh said.

THE WEIGHTING GAME

The Fed's mission is far from accomplished. Annual headline and core CPI – as well as personal consumption expenditures (PCE) inflation, the Fed's preferred measure – have all been above the central bank's 2% target for more than five years. This is the longest that core PCE has been persistently above target since 1987-1994.

That's an uncomfortable record for any Fed chair to defend, especially one who has been in the job for barely a month and whose primary task is to convince Americans that years of price "instability" are over.

Given that Warsh was nominated by a president who has aggressively called for rate cuts despite high inflation, the new Fed chair will want to prove to consumers, businesses, and financial markets that his inflation-fighting credentials are above reproach.

"The members of our committee have no tolerance for persistently elevated inflation. And we share a resolute commitment to restoring price stability," he told lawmakers.

You wouldn't expect him to say anything else. But markets will now watch to see whether that strong rhetoric is backed by action. If June's CPI surprise proves to be just a flash in the pan, not the beginning of a longer-term trend leading back to target, will Warsh be willing to hike?

Attention now turns to the June PCE inflation report, which will be released on July 30. The weightings and calculation methodologies used by PCE and CPI are different, so there is unlikely to be as big a downward surprise in two weeks’ time.

Software, which rose sharply in the CPI report, has a much larger weighting in the PCE index. Shelter, which accounted for much of the CPI weakness, has a 35% weighting in CPI versus only 16% in PCE.

Economists at Goldman Sachs and Pantheon Macro are among those who reckon core PCE slowed a touch to 3.3% in June from 3.4% in May. That would be a move in the right direction, but not a significant one.

CURVES STEEPEN

Meanwhile, the economy is still running hot, and energy prices are rising again, with U.S. crude CLc1 now 20% higher than a year ago. The year-on-year change briefly turned negative last month after a ceasefire between the U.S. and Iran was announced, but a resumption of hostilities has deflated that particular balloon.

Oil is directly excluded from core inflation, of course, but it has an indirect impact through second-round effects. Rising production and transportation costs typically pass through to higher food and core prices, while more expensive oil can also raise inflation expectations, indirectly lifting core prices.

Markets certainly don’t think the inflation mission is accomplished. While implied rates and short-dated yields fell on Tuesday, other signals from the bond market suggested investors think delaying rate hikes — or not tightening at all — might be a mistake.

The U.S. yield curve steepened as short-dated yields fell more sharply than their longer-dated counterparts, with the gap between 2-year US2YT=RR and 10-year US10YT=RR yields widening the most since May and the 2s/30s spread widening the most since March.

Similarly, short-dated breakeven inflation rates fell while longer-term rates were largely steady. Breakeven inflation is the difference between the yield on a nominal bond and the yield of an inflation-linked bond of the same maturity, an implicit forecast of average inflation over the relevant time horizon.

All these moves indicate traders believe longer-term inflation pressures will persist if the Fed doesn't tighten policy sufficiently.

In an ideal world, Warsh would likely prefer to let inflation drift lower on its own, giving the Fed leeway to support the labor market with rate cuts if needed. But as his colleague Chris Waller said on Monday, “sternly staring at inflation” may not be enough.

(The opinions expressed here are those of the author, a columnist for Reuters)

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