(The opinions expressed here are those of the author, a

columnist for Reuters.)

By Jamie McGeever

ORLANDO, Florida, July 15 (Reuters) - Federal Reserve Chair

Kevin Warsh no doubt welcomed last month's surprise fall in U.S.

inflation, but his breathing room on interest rates will be

limited.

Figures on Tuesday showed price pressures cooled much more

than expected in June, especially in the "core" consumer price

index (CPI), which excludes food and energy. This prompted the

biggest scaling back of Fed tightening expectations in interest

rate futures markets since February.

That makes Fed Governor Christopher Waller's comments on Monday

about the potential need for a hike sooner rather than later

ring a little hollow, and many economists say the Fed may not

move at all this year.

While this softer core CPI print offers cause for cautious

optimism, one should be careful about putting too much stock in

one month's numbers. Warsh himself said as much on Tuesday,

telling U.S. lawmakers he would not "cherry-pick" the moment as

a sign of progress.

"There might be some that look at this morning's data and

say, 'Oh, mission accomplished, everything is swell.' That is

not my view," Warsh said.

THE WEIGHTING GAME

The Fed's mission is far from accomplished. Annual headline and

core CPI - as well as personal consumption expenditures (PCE)

inflation, the Fed's preferred measure - have all been above the

central bank's 2% target for more than five years. This is the

longest that core PCE has been persistently above target since

1987-1994.

That's an uncomfortable record for any Fed chair to defend,

especially one who has been in the job for barely a month and

whose primary task is to convince Americans that years of price

"instability" are over.

Given that Warsh was nominated by a president who has

aggressively called for rate cuts despite high inflation, the

new Fed chair will want to prove to consumers, businesses, and

financial markets that his inflation-fighting credentials are

above reproach.

"The members of our committee have no tolerance for

persistently elevated inflation. And we share a resolute

commitment to restoring price stability," he told lawmakers.

You wouldn't expect him to say anything else. But markets

will now watch to see whether that strong rhetoric is backed by

action. If June's CPI surprise proves to be just a flash in the

pan, not the beginning of a longer-term trend leading back to

target, will Warsh be willing to hike?

Attention now turns to the June PCE inflation report, which

will be released on July 30. The weightings and calculation

methodologies used by PCE and CPI are different, so there is

unlikely to be as big a downward surprise in two weeks' time.

Software, which rose sharply in the CPI report, has a much

larger weighting in the PCE index. Shelter, which accounted for

much of the CPI weakness, has a 35% weighting in CPI versus only

16% in PCE.

Economists at Goldman Sachs and Pantheon Macro are among

those who reckon core PCE slowed a touch to 3.3% in June from

3.4% in May. That would be a move in the right direction, but

not a significant one.

CURVES STEEPEN

Meanwhile, the economy is still running hot, and energy prices

are rising again, with U.S. crude now 20% higher than a

year ago. The year-on-year change briefly turned negative last

month after a ceasefire between the U.S. and Iran was announced,

but a resumption of hostilities has deflated that particular

balloon.

Oil is directly excluded from core inflation, of course, but

it has an indirect impact through second-round effects. Rising

production and transportation costs typically pass through to

higher food and core prices, while more expensive oil can also

raise inflation expectations, indirectly lifting core prices.

Markets certainly don't think the inflation mission is

accomplished. While implied rates and short-dated yields fell on

Tuesday, other signals from the bond market suggested investors

think delaying rate hikes - or not tightening at all - might be

a mistake.

The U.S. yield curve steepened as short-dated yields fell more

sharply than their longer-dated counterparts, with the gap

between 2-year and 10-year yields

widening the most since May and the 2s/30s spread widening the

most since March.

Similarly, short-dated breakeven inflation rates fell while

longer-term rates were largely steady. Breakeven inflation is

the difference between the yield on a nominal bond and the yield

of an inflation-linked bond of the same maturity, an implicit

forecast of average inflation over the relevant time horizon.

All these moves indicate traders believe longer-term

inflation pressures will persist if the Fed doesn't tighten

policy sufficiently.

In an ideal world, Warsh would likely prefer to let

inflation drift lower on its own, giving the Fed leeway to

support the labor market with rate cuts if needed. But as his

colleague Chris Waller said on Monday, "sternly staring at

inflation" may not be enough.

(The opinions expressed here are those of the author, a

columnist for Reuters)

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(By Jamie McGeever

Editing by Marguerita Choy)