“When U.S. Federal Reserve officials meet in two weeks, they are likely to conclude that the economic outlook has strengthened and inflation is a little less quiescent,” writes Greg Ip in today’s Wall Street Journal.

“During the past few weeks U.S. government reports have shown much stronger job growth and retail sales and bigger increases in consumer prices than private economists and Fed officials expected.”

“These developments are almost certainly too tentative for the Fed to raise interest rates at its meeting on May 4. But the central bank will likely continue what officials refer to as ‘verbal tightening’ of monetary policy: altering the statement that follows the meeting to convey that conditions for such an increase are falling into place. Fed policy makers’ purpose is twofold: to be candid in their economic views, and to adjust investors’ expectations so that when the Fed finally does lift rates, it isn’t a surprise.”

“The most likely changes to the Fed’s statement are a recognition that U.S. job growth is improving following March’s 308,000 jump in nonfarm jobs, a four-year high, and that the inflation rate has stopped falling. So, Fed policy makers will probably say the risks of inflation are balanced, unlike recent statements that warned of a small risk of it falling too far.”

“Whether the Fed repeats that it can be ‘patient’ about raising interest rates isn’t as certain. Some officials might press to drop the phrase to give themselves more latitude to raise rates quickly if the U.S. economic expansion remains surprisingly sturdy. Markets might interpret that as a signal rates could rise in June. (They now see August as the most likely time for an increase.)”

“But Fed governor Donald Kohn said in a recent speech that ‘patient’ doesn’t only mean the Fed can be slow to start raising its target for the federal-funds rate, charged on overnight loans between banks, and now at a 46-year-low of 1%. It could also mean that the Fed starts soon, but is slow to return the rate to a normal level.”

“Under that logic the Fed could retain its commitment to patience. As long as markets understood that logic, the commitment wouldn’t preclude the Fed from raising rates whenever it likes, but would discourage investors from pricing in a rapid series of rate increases.

Some analysts argue the Fed is already letting inflationary pressure build dangerously. As evidence, they point to the 0.4% jump in consumer prices excluding food and energy in March, the biggest since late 2001.”

“But Fed officials don’t share that view. First, they figure that 0.4% translates to a not-as-alarming 0.2% to 0.3% rise in the lesser-known index of personal-consumption expenditures, their preferred inflation gauge. Second, the past year’s sharp jump in energy and commodity prices, which recently fed through to consumers, is leveling off. Third, and perhaps most important, rising productivity and soft wage gains are still pushing down labor costs, the critical determinant of inflation pressure.”

“That is apparent in the latest U.S. manufacturing data. On Friday, the Fed reported that industrial production declined 0.2% in March from February, the first drop since May. Much of that was due to a decline in utilities output. Manufacturing production was unchanged, as declining auto assemblies were offset by increased output of food, chemicals and computers. Manufacturers used just 75.2% of capacity during March, down from 75.3% in February.”

“Meanwhile, the number of hours worked at manufacturers fell during March, implying that output per hour — productivity — actually rose a healthy 0.4%. That is faster than the 0.2% increase in hourly wages, so adjusted for productivity, factory labor costs declined in March. Indeed, while manufacturers continue to report buoyant sales gains, high unemployment has put a lid on manufacturing wage increases, which have slowed to 1.9% from 3.2% a year earlier.”

“While job creation in the U.S. has picked up, more than a million workers stopped looking for jobs in recent years, many of whom will now resume the hunt, holding up the unemployment rate. Unused factory capacity, high unemployment and healthy increases in ‘productivity will help keep inflation under control for the next couple of years,’ Fed governor Ben Bernanke said last week.”