The Federal Reserve is expected to keep US interest rates steady when its policymaking panel meets tomorrow, despite ominous signs that inflation is taking a hefty bite out of household budgets while economic growth remains stagnant.

The Beige Book survey of economic conditions in the 12 Federal Reserve districts, which is prepared prior to each meeting of the central bank's Federal Open Market Committee (FOMC), said all 12 districts reported "elevated or increasing" price pressures during June and July amid rising costs for fuel, metals and food.

Jeffrey Rubin, chief economist of Toronto-based investment bank CIBC, said last week that inflation in America could soar to 6% by the autumn - a level last seen in 1982.

His reasoning: increased shipping costs are making goods produced in the United States more competitive with goods shipped from China.

"High energy prices give American manufacturing workers bargaining power that they have lacked for over a decade, while at the same time encouraging them to ask for larger pay raises to keep pace with the soaring price of gasoline," Rubin wrote in a research note.

"If workers can bargain for cost-of-living increases, sparking further inflation, then interest rates will rise too," Rubin predicted.

"The last time we saw 6% inflation in 1990, the federal funds rate was running at around 7.5% - over three times today's setting. And a 10-year Treasury bond was yielding 8.5% - over double what it yields today."

Wall Street traders, analysts and economists will be watching the statement that accompanies the Fed decision for signs the bank is going to step up its fight to stifle inflationary pressures.

They will be looking for evidence that Fed chairman Ben Bernanke and his colleagues on the FOMC plan to bump up the cost of borrowing later this year or in early 2009.

However, Bernanke wants to hold off increasing the cost of credit for as long as possible to avoid tipping the economy into recession while at the same time hoping inflation does not spiral out of control.

J Alfred Broaddus, former president of the Richmond, Virginia Fed, said the central bank faces a tough call.

"There are lots of downside risks to growth," he said. "But if you see inflation expectations getting some momentum, you have to act."

A Deutsche Bank index using various measures to gauge financial conditions shows that despite a string of rate cuts since mid- September, conditions are still weak and are likely to keep economic growth depressed.

Third-quarter growth also presents a challenge for an economy that so far has avoided a clear recession. As the impact of government tax rebate cheques fades away, stagnation - or worse - in retail spending is possible.

However, for many Americans, the threat of inflation poses a greater risk than recession. US consumers foresee average annual inflation of 3.4% during the next five years, the highest expectation since 1995, according to the Reuters/University of Michigan survey. Consumer prices climbed 5% in June from a year earlier.

Prices for milk and petrol "are already affecting inflation expectations," said Mark Spindel, chief investment officer at Potomac River Capital, a hedge fund in Washington, DC. Those expectations could "become entrenched in wage demands".

So far, wage demands from US workers have been muted, largely because many employees fear losing their jobs if they ask for a substantial rise during the present economic downturn.

Bernanke may face a mauling from three anti-inflation hardliners on the FOMC during this week's deliberations that may test his apparent desire to keep interest rates steady until the smoke clears a bit more in financial markets.

Wall Street analysts sense that the outcome predicted by financial markets for the meeting - no change in the key federal funds rate - will come only after a bruising debate.

"Hawkish comments from Philadelphia Fed president Charles Plosser raise the odds that three FOMC members will dissent at the August meeting," said economists at Lehman Brothers. "It would be the first time since November 1992."

Plosser said late last month that the Fed should start to reverse its course "sooner rather than later", echoing comments by Minneapolis Fed president Gary Stern.

"We can't wait until we clearly observe the financial markets at normal, the economy growing robustly, and so on," said Stern, the Fed's longest-serving regional president but one who has not joined this year's jamboree of dissenters.

Dallas Fed chief Richard Fisher is arguably the ring-leader among the inflation hawks. Of Fed officials who get a vote this year on rates, Fisher has been the most outspoken and has already registered four dissents in favour of tighter policy.

Even with dissent in the air, financial markets see just a 10% chance for an increase in benchmark overnight rates in August from their current 2%.

By September, however, perceived prospects for a rate increase jump to 68%. Dealers fully price a rise by October and a possible year-end federal funds rate of 2.5%.

Still, Bernanke seemed to imply in recent congressional testimony that the Fed is still some way from a rate increase. If he prevails, the sense of his leadership of the Fed will be enhanced.

In contrast to the recent sharp rhetoric from Stern and Plosser, Bernanke suggested to Congress that greater stability in the financial system needs to be achieved before the Fed will act.

The global credit crunch, approaching its first anniversary this month, has produced several false dawns, only to catch markets and policymakers by surprise by taking a new and more damaging turn.

The assessment offered by the FOMC after its last meeting in late June that downside risks to growth had "diminished somewhat" was summarily dropped by Bernanke in his remarks to Congress.

"Chairman Bernanke is clearly first among equals. Therefore, conflicts between his take on the world and those of other members should generally be resolved in his favour," Ed McKelvey, an economist at Goldman Sachs, said in a research note.

Indeed, a study by the economic forecasting firm Macroeconomic Advisers showed that Bernanke towers above the other members of the rate-setting panel in his ability to move markets, and presumably to telegraph the path of monetary policy.

More tolerance for open dissent seems to be a hallmark of the Fed under Bernanke's leadership, making the prospect of three dissents less of a crisis than it might appear.