By Richard Leong and John Parry (Reuters)

NEW YORK - The Federal Reserve is in a race against time to reassure the bond market it hasn't lost its grip on inflation while not losing sight of a U.S. economy still vulnerable to a recession.

Although most analysts do expect the Fed to hold its benchmark interest rate steady through the summer, traders are already sweating over the lurking dangers that could force the U.S. central bank's hand.

The U.S. dollar could fall again, commodity prices could continue to rise to new records, and other central banks could move first to raise interest rates to restrain inflation and leave the Fed standing.

"Some traders are worried the Fed may have lost its grip on inflation," said Rob Kurzatkowsi, an analyst at optionsXpress in Chicago.

First to sound the alarm may be the U.S. Treasury bond market which is already nervous that the Fed may leave U.S. consumers at the mercy of spiraling inflation.

If U.S. consumer inflation expectations, already at an eyebrow-raising 7.7 percent, continue to accelerate this summer, bond yields may rise further in anticipation of a rate rise from the Fed in the fall.

"What do fixed income investors desire? A positive real return on their money," said Michael Pento, senior market strategist with Delta Global Advisors in Huntington Beach, California.

"As time goes by and as fact that inflation is the new paradigm is accepted by investors, they will have to price it into the Treasury market and I would not be surprised if yields (of 10-year notes) are significantly above 5 percent by the end of the year," said Pento.

Currently U.S. CPI inflation is running above 4.0 percent annually meaning most longer term U.S. Treasury bond yields are barely covering inflation or maintaining investor purchasing power.

WITHERING EXPECTATIONS

The deterioration in inflation expectations on Main Street has been reflected on Wall Street. One of the troubling signposts is the rapid expansion of the "breakevens" or the yield difference between Treasury Inflation-Protected Securities and regular Treasury notes and bonds.

The breakevens between 10-year TIPS and 10-year Treasuries, a market gauge monitored by the Fed, have widened by a quarter percentage point from a month ago.

"That the Fed should raise rates against inflation is absolutely abundantly clear to me," Pento said.

Last week, hawkish remarks from Fed officials roiled the Treasury market, pushing yields to fresh highs for the year.

"Once those inflation expectations break out it's too late. We need to act preemptively to make sure they are contained," Philadelphia Fed President Charles Plosser told CNBC television.

FED'S DILEMMA

But raising interest rates is a difficult option for Fed policy-makers right now, given the slowdown in U.S. economic growth in the past year.

"The Fed is in a box. All they can do is talk: they cannot act. In my opinion (Fed Chairman) Ben Bernanke will lose his credibility," Pento said.

The U.S. housing market is still mired in an unprecedented slump. The banking sector is struggling from bad loans and asset-write-downs. Consumers are scaling back spending due to record gasoline prices and a faltering job market.

The Fed "cannot cut rates in an environment of rising unemployment and very high rates of rising foreclosures," said Pento who expects the Fed won't be able to raise rates more than 25 basis points by year end.

In light of recent data showing somewhat contained "core" inflation, excluding food and energy prices, and weaker-than-expected manufacturing activity, investors have begun to reassess whether last week's dramatic sell-off was overblown.

"The economy will remain more sluggish than most people think," said Tom Girard, co-portfolio manager for the MainStay Income Manager Fund in New York. Girard expects the Fed to hold rates through year-end.

Still, the Fed can ill-afford to wait long in raising rates as their overseas counterparts trumpeted their intentions to raise rates soon. The European Central Bank has signaled it could raise rates as early as July.

If the Fed holds rates as other countries raise theirs, the widening interest rates differentials could undermine the U.S. dollar again and fuel inflation further.

Before the end of the year, "I look for continuation of the falling dollar to break below 70 on the dollar index .DXY and for gold to retest its all-time high around $1,030 an ounce," Pento said.

A further relapse of the dollar may also hurt foreign demand for Treasuries and other U.S. investments, analysts said.

"They don't have the luxury to be on the sidelines to wait-and-see," said MainStay's Girard. A further relapse of the dollar may also hurt foreign demand for Treasuries and other U.S. investments, analysts said.

"They don't have the luxury to be on the sidelines to wait-and-see," said MainStay's Girard.