Bernanke's inflation warning triggers Wall Street sell-off

US stock and bond markets plunged and the dollar moved higher yesterday, after Ben Bernanke warned that the economy was slowing - but hinted that rising inflation might none the less force the central bank to push up interest rates in the weeks ahead.

Addressing a conference of the American Bankers Association here, the Federal Reserve chairman said the recent rise in core inflation, to an annualised 3.2 per cent as measured by one index, was "unwelcome." The Fed would be "vigilant" to ensure this trend did not last.

At the same time, he added, it was "reasonably clear" that the US economy had entered "a period of transition," and that "the anticipated moderation of economic growth seems now to be under way". This hint of a perfect storm for the markets - a slowing economy coupled with the prospect of higher interest rates - was enough to drive the Dow down 199 points, almost 2 per cent, on the day, while the bond market weakened.

The dollar, however, moved off a 13-month low against the euro, despite the near certainty the European Central Bank will increase its own key short-term rate by at least a quarter of one percentage point to 2.75 per cent on Thursday.

Mr Bernanke's remarks make it likelier that the US central bank will nudge interest rates even higher when the policymaking Federal Open Market Committee meets at the end of this month.

The Fed has already boosted its benchmark federal funds to 5 per cent with 16 consecutive increases of 25 basis points over the past two years.

Interest rate futures suggest a 74 per cent likelihood that FOMC will lift the target rate to 5.25 per cent, compared with a 50 per cent likelihood before the chairman spoke.

None the less some analysts believe that Mr Bernanke, who has been in his job for barely four months, may just be talking tough, to prove his anti-inflation credentials. They argue that with the economy already starting to cool, the Fed will only raise rates most reluctantly, if at all.

Mr Bernanke's speech was his most detailed assessment of the economy yet - and delivered in a far more explicit fashion than his famously sibylline predecessor, Alan Greenspan.

The latest data supports his thesis. After surging at a pace of 5.3 per cent in the first quarter, US GDP is expected to expand by little more than 3 per cent for the whole of 2006. Only 75,000 new jobs - far fewer than had been expected - were created in May, government figures have shown, while growth in the service sector last month, according to a closely watched index yesterday.