The fear that inflation may be rearing its ugly head pounded financial stocks on Friday.

In early afternoon trading, the Philadelphia KBW Index fell 1% to its lowest point of the year. The AMEX Broker Dealer Index dropped 1.7%.

Bank and brokerage stocks began sliding from the opening bell, after the federal government reported that core inflation rate rose 0.8% in January -- the biggest jump in six years. The core rate, which excludes energy and food price, was driven higher by a combination of surging tobacco and automobile prices.

Of course, one month doesn't signal a trend, but Wall Street interpreted the inflation number in the worst possible light, selling government bonds in anticipation the

Fed

will have to hike interest rates more than previously feared. A rapid rise in interest rates is often a stock market killer.

At midday, the yield on the 10-year Treasury bond was 6 basis points to 4.24%. (Bond yields move in the opposite direction of bond prices).

Ironically, it was just a week ago when some on Wall Street were starting to talk about another wave of mortgage refinancings, after the yield on the 10-year bond fell briefly below 4%.

The prospect of increasingly higher interest rates hit some financials harder than others, with

Morgan Stanley

(MWD)

falling farther than any other major bank or brokerage stock. In afternoon trading, shares of the big Wall Street firm were off $1.85, or 3.1%, to $57.76.

Overall, the stocks feeling it the most were shares of mortgage banks and Wall Street firms, with big bond-trading and debt-underwriting operations. Among that group, the stocks tumbling the most were

Bear Stearns

(BSC)

, down $2.35, or 2.3%, to $97.92;

Lehman Brothers

(LEH)

, off $1.72, or 1.9%, to $89.93;

Countrywide Financial

(CFC)

, down 74 cents, or 2%, to $35.31 and

Doral Financial

(DRL)

off $1.07, or 2.5%, to $42.16.

Also taking a beating were shares of

Fannie Mae

, down $1.98, or 3.3%, to $58.63 and

Freddie Mac

, off $1.44, or 2.3%, to $62.46.

Shares of the government-sponsored mortgage finance firms were reeling from the combination of rising bond yields and critical comments Thursday by Federal Reserve Chairman Alan Greenspan about the size of the two companies. In testimony before a congressional panel, Greenspan said limits should be placed on the size of each firm's mortgage portfolio.

Friday's events were another rude reminder of why financials may be a tough place for investors to make money in 2005.