June 13 (Bloomberg) -- One week ago, the likelihood that the Federal Reserve would raise its benchmark interest rate at the Aug. 5 meeting was zero, according to fed funds futures prices. Yesterday, the odds were better than 65 percent.

Expectations travel faster than the speed of sound nowadays. No moorings to come unhinged here, thank you very much. This boat is drifting anchorless at sea.

The rout, or rise, in short-term interest rates this week started in Europe and worked its way across the pond. The December Eurodollar futures contract, which reflects expectations for rates in the ensuing three months, slumped 65 basis points in two days -- June 9 and 10 -- alone.

The sell-off was aided and abetted by real or perceived hawkish comments from Federal Reserve Chairman Ben Bernanke.

``Inflation has remained high,'' Bernanke told the attendees at the Boston Fed's 52nd annual economic conference in Chatham, Massachusetts, on June 9 in a statement of the obvious.

So far, there's been only limited pass-through from soaring raw materials costs to consumer prices and wages, a result of soft domestic demand, he said. ``The continuation of this pattern is not guaranteed.''

To ensure that it continues, the Fed will ``strongly resist an erosion of longer-term inflation expectations.''

This followed by a week Bernanke's groundbreaking comment that the weak dollar had implications for inflation and inflation expectations.

Of course, he also told the Boston Fed conference that ``growth risks remain to the downside,'' but no one seemed to be listening.

Choppy Seas

And those risks are still there, which is why, hawkish talk notwithstanding, the Fed isn't about to rock the still shaky boat.

``They are not about to do a multistep tightening,'' said Paul Kasriel, chief economist at Northern Trust Corp. in Chicago. ``If they did, it would be aborted very quickly.''

Kasriel doesn't discount the possibility of a little cosmetic tightening. ``It's conceivable they could show their inflation-fighting credentials and bump the funds rate up 25 basis points in August,'' he said. ``But I don't think they will.''

Yesterday's retail sales for May showed surprising strength, rising 1 percent. That changes the arithmetic of second-quarter gross domestic product. It doesn't change the fundamentals driving the economy.

Housing prices are falling.

The unemployment rate is rising.

Non-residential investment is slowing.

Business confidence is slumping.

The U.S. auto industry is dead.

State and local governments are cutting back.

Bank credit has been falling since March.

The Fed's monetary base is barely growing in nominal terms.

``There's no there there'' for a second-half recovery, said Bob Barbera, chief economist at ITG Inc., a New York brokerage, who expects ``an extended period of below-trend growth.''

Against a backdrop of soaring food and energy prices, any inkling of recovery sends the bond market into a tailspin. ``There can be no acceleration in economic growth without embedding it in the inflation outlook,'' Barbera said, translating the market mindset.

Economists at Goldman Sachs Group Inc. are also resisting the rising tide of expectations of higher interest rates. The reasons, as chief economist Jan Hatzius outlines in a recent commentary, are: increased slack in the economy, with rising unemployment curbing whatever impetus there might be for higher wages; data on inflation and inflation expectations that have been ``mixed rather than downright awful''; and a dollar that has been stable on a trade-weighted basis since late February.

Anchors Away!

What's more, ``prior sell-offs at the front end of the yield curve have sometimes proven to be poor predictors of policy,'' Hatzius said.

Not to mention what the Fed says. It was only last August that policy makers viewed the risks to the economy as weighted toward higher inflation. One month later, the Fed cut the interbank rate by 50 basis points, followed by another 275 basis points in the next seven months.

So what to make of the recent rhetoric from Bernanke and other members of the policy committee?

``I think the Fed is uncomfortable with the funds rate below the inflation rate,'' Kasriel said.

As well they should be. The economic consequences of a negative real funds rate are pretty clear. With central bankers around the globe aware of the cost of restraining inflation and their own credibility once the genie is out of the bottle, you can't blame them for talking tough.

Adrift at Sea

The question is, can they or will they follow through? The Fed is independent, yes; it's not immune to political realities. After facilitating and financing the purchase of Bear Stearns Cos. by JPMorgan Chase & Co. in March, how would members of Congress react to a rate increase at a time when their constituents are struggling to buy food and gas for their families?

Bernanke is certain to be reminded of the Fed's dual mandate -- maximum sustainable employment and price stability -- when he testifies before the Senate Banking and House Financial Services committees in July.

Maybe that's why, as Kasriel's Northern Trust colleague, Asha Bangalore, points out, the Fed has never raised the federal funds rate until after the unemployment rate starts falling.

The Fed is in no position to raise interest rates. The U.S. economy is in or close to recession. Americans are losing their jobs, their homes, their wealth and their confidence.

Policy makers stress the importance of anchoring inflation expectations. They probably would be willing to tolerate a little drift when the alternative is sinking the ship.

(Caroline Baum, author of ``Just What I Said,'' is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: June 13, 2008 00:03 EDT