The latest challenge came Wednesday morning, when the government reported that its consumer price index rose 0.4% in January. The core CPI, which excludes volatile food and energy prices, was up 0.3%. Both readings exceeded expectations on Wall Street and spooked an already fragile stock market.

In minutes from the last Fed meeting released Wednesday afternoon, the central bank revealed that officials generally agreed that inflation data since December has been "disappointing," but the Federal Open Markets Committee agreed to cut its key interest rate target by a half-point anyway to combat the risks of an economic downturn.

"With no signs of stabilization in the housing sector and with financial conditions not yet stabilized, the committee agreed that downside risks to growth would remain even after this action," the Fed said in the minutes of its two-day meeting ended Jan. 30.

Some members of the committee noted that when prospects for economic growth improve, rates can be raised back up -- possibly in a rapid fashion -- to head off inflation. Many members said an economic slowdown anticipated in the first half of 2008, coupled with a "leveling-off" of energy and commodity prices, should ease inflation pressures.

Since then, energy and commodity prices have continued to spike higher, but the fed funds futures showed that investors aren't retreating from a near unanimous certainty that the Fed will again slash its key interest rate target by another half a percentage point in March. It has already lowered the fed funds rate by 225 basis points since September, even as inflation has climbed steadily higher.

"The fixed-income markets remain broken," says T.J. Marta, fixed-income strategist with RBC Capital Markets. "The Fed needs to ensure that the banking system can survive and part of doing that is steepening up the yield curve. It's a lousy situation."

The situation is made even lousier by rising commodity prices, including those for agricultural products. The price of wheat has more than doubled since last May. Crude oil prices are hovering around $100 a barrel, which flies in the face of the long-held Fed view that energy prices will moderate. Also, food costs climbed 0.7% in January.

Inflation has also shown up in some corporate earnings reports. The world's largest retailer, Wal-Mart (WMT - commentary - Cramer's Take), reported a fourth-quarter sales increase of 8.3% that was largely powered by new store openings and increases in food and energy prices. Its sales at stores open for at least a year rose 1.6% for the quarter, but excluding fuel sales, they were up 1.4%. The company doesn't break out food prices.

"Wal-Mart's sales were likely much weaker than the headline number, reflecting inflation," says Barry Ritholtz, chief investment officer with Fusion IQ and a contributor to RealMoney.com, a sister site to TheStreet.com. "We suspect that's why the company lowered its [outlook for the current quarter and the full year] ."

Consumer prices rose 4.3% on a year-over-year basis in January, which marks the biggest increase since September 2005. The core CPI was up 2.5% compared to January 2007, still the highest annual rate since last March. Over the past three months, core inflation has risen at a 3.1% annual rate, well above the Fed's presumed comfort zone of around 1.5% to 2%.

In the last Fed meeting, Dallas Fed governor Richard Fischer dissented from the vote to ease rates, preferring to hold pat after supporting a three-quarter point emergency rate cut announced after a global selloff in the stock market earlier in January.