May 31 (Bloomberg) -- The surge in food and gasoline costs is fueling inflation expectations among consumers, threatening to limit the Federal Reserve's leeway in fighting off a recession.

Reports this week from the Conference Board and Reuters/University of Michigan showed that consumers' forecasts for price increases jumped in May as their overall confidence slumped.

``This is sure to be creating concern at the Fed,'' said Brian Sack, a former Fed economist who's now at St. Louis-based Macroeconomic Advisers LLC. ``They don't want to see some kind of inflationary psychology begin to take hold.''

The Fed's concern: that inflation worries cause workers to demand bigger pay increases to make up for the loss of buying power, setting the stage for a wage-price spiral reminiscent of the late 1970s. Dallas Fed President Richard Fisher made clear this week that policy makers were determined to prevent that from happening.

Inflation expectations for the year ahead as measured by the Conference Board rose to 7.7 percent in May from 6.8 percent in April.

``Consumers' inflation expectations, fueled by increasing prices at the pump, are now at an all-time high and are likely to rise further in the months ahead,'' said Lynn Franco, director of the board's Consumer Research Center in New York.

Richard Curtin, who runs the Reuters/University of Michigan consumer survey, said households are beginning to believe that higher inflation may be here to stay.

Highest Since 1995

His survey found that consumers expect inflation to average 3.4 percent over the next five years, the most since 1995 and up from 3.2 percent in April. Consumer prices rose 3.9 percent in year ended in April.

``The Fed claims to pay close attention to this series,'' John Ryding and his fellow economists at Bear Stearns Cos. in New York said in a note to clients. ``It suggests that inflation expectations are beginning to become unmoored, which could put the Fed in a very difficult position later in the year.''

Traders in the federal funds futures market in Chicago see about a one-in-three chance that the Fed will raise rates at least once over the next four months to try to keep inflation in check.

Fed policy makers would raise interest rates ``sooner rather than later'' should price expectations continue to worsen, even if the economy is weak, the Dallas Fed's Fisher said in a May 28 speech in San Francisco.

Wage Inflation

The University of Michigan's Curtin said the future course of inflation will be determined by what happens to wages. If workers win bigger pay raises, inflation may accelerate.

So far that doesn't seem to be happening, a point made by San Francisco Fed President Janet Yellen in a speech on May 27.

``There is no evidence that wages have started to spiral up,'' she told a conference in San Francisco.

Average hourly earnings of production workers rose 3.4 percent in April from the same month last year. That's down from 3.7 percent in March and 4.2 percent at the start of last year.

Macroeconomic Advisers' Sack said that Fed policy makers could also take some comfort from the fact that investors' inflation expectations remain contained.

Long-term inflation expectations, derived from the market for the Treasury Inflation-Protected Securities, stand at about 2.58 percent, down from a 2008 high of 2.7 percent on March 10.

To contact the reporter on this story: Rich Miller in Washington at rmiller28@bloomberg.net

Last Updated: May 31, 2008 00:01 EDT