Economy Better, but Not Yet Out of Woods

While stocks have rallied from their March lows and credit conditions have improved, the current economic slowdown could only be in its infancy as the effects of the U.S. housing downturn play out on Main Street.

The improving picture on Wall Street has fed the widespread belief that the Federal Reserve will end its nine-month rate-cutting campaign at its June meeting, as it eyes the growing threat of inflation.

U.S. Treasury Secretary and former Goldman Sachs (GS Quote) CEO Henry Paulson said in an interview published in the Wall Street Journal Wednesday that the "worst is behind us" in the credit crisis. That was echoed by Merrill Lynch (MER Quote) CEO John Thain in India, where he was assessing the firm's operations.

Both men, however, also warned that full recovery was still months away, particularly as problems for the U.S. consumer mount. As oil prices and other commodities soar and the value of the U.S. dollar weakens, a growing chorus of well-respected Fed watchers has warned that excess liquidity in the financial system is exacerbating inflation, an economic cancer that has lain dormant in the U.S. now for decades.

Federal Reserve Bank of Kansas City President Thomas Hoenig, in a speech in Denver Tuesday, said consumers are adopting an "inflation psychology to an extent that I have not seen since the 1970s and early 1980s" and intimated the Fed might need to raise rates to battle the problem.

Despite this threat, many economists say the continued decline in home prices will require further easing from the Fed to cushion the resulting economic damage. Like Fed Chairman Ben Bernanke, these prognosticators say that deteriorating economic conditions should ultimately be enough to contain inflation and reverse the crippling runup in fuel prices, with crude oil futures recently priced above $120 a barrel.