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Updated from 1:53 p.m. EST

With all eyes on

Federal Reserve

nominee Ben Bernanke's confirmation hearing, the bond market found new confidence Tuesday that inflation has a worthy opponent. That's saying a lot considering the rest of the day's data.

The benchmark 10-year Treasury note close up 12/32 while its yield, which moves inversely and reflects the market's inflation expectations, fell to 4.56%.

"Currently, inflation is above the range which in the long run would be desirable," Bernanke said. But as part of his emphasis to maintaining Fed Chairman Alan Greenspan's policies, he said that policymakers' emphasis should remain on core inflation, which does not include energy prices.

Asked about the risk of an energy shock as heating costs hit consumers during this winter's heating season, Bernanke said the economy was sheltered by "well-anchored inflation expectations."

In the 1970s, less confidence existed about the central bank's ability to contain inflation, and inflationary pressures easily moved from energy to core prices, he said. This, combined with excessive tightening by the Fed at the time, pushed the U.S. economy into recession.

"But in the most recent episode, core inflation remains very well contained. Therefore, the Fed has been able to raise rates to 4.0% and the economy has still been able to grow strongly," Bernanke said.

Coinciding with Bernanke's remarks, the October producer price index showed higher-than-expected headline inflation while core prices remained subdued. The PPI rose 0.7% in October, compared with economists' expectations for an unchanged reading. But, excluding food and energy, the core PPI fell 0.3%, compared with expectations for a 0.2% increase.

According to Goldman Sachs chief economist Bill Dudley, the PPI still revealed rising pipeline inflation pressures, as core intermediate prices rose 1.2% for the second month in a row.

At the same time, retail sales were stronger than expected in October, pointing to the resilience of consumers to high energy costs, which have cooled in recent weeks; on Tuesday, crude futures

closed below $57 per barrel, its lowest close since early June.

Bernanke's comments implied that the economy has withstood both rising energy costs and the Fed's rate hikes so far and confirmed expectations that under his leadership, the Fed will continue to hike rates.

"The Fed has emphasized that between growth and inflation, the greater risk of the two is inflation," says Joel Naroff, president of Naroff Economic Advisors. Bernanke "hasn't indicated that the Fed's view has changed and said nothing to contradict

the idea that the Fed will continue lifting rates."

Chicago Fed president Michael Moskow also said in a speech Tuesday that the Fed will continue to lift interest rates to keep both inflation and inflation expectations contained.

The market fully expects the Fed to hike rates by another quarter point when it meets on Dec. 13, and sees a 90% chance it will do so again on Jan. 31. This would take the fed funds rate to 4.50%. Fed funds futures are also pricing in a 66% chance that the Fed will again hike rates on March 28.

But while short-term rates have been rising along with expectations of more rate hikes, long-term yields seem to have stopped rising since last week, indicating that inflation expectations might be reflected in bond prices for now. The price of gold, which often rises along with inflation expectations, has fallen from its recent 18-year high but rose 0.3% to $469 per ounce Tuesday.

Meanwhile, the yield curve, which plots the yields of short- and long-term bonds, keeps on flattening. The spread between the yield of the two-year government bond -- which closed at 4.46% -- and that of the 10-year has narrowed to 10 basis points. A spread this narrow normally points to market expectations of an economic slowdown. When the yield curve inverts, it's signaled, in the past, that a recession is coming.

There remains a debate among economists about what the market is really saying. Does it merely expect inflation to be contained by rising interest rates, or does it believe the economy will actually fall apart?

"If home prices break, and there are signs that they've begun to do so,

home equity extraction which has funded a lot of consumer spending, will slow," says NEA's Naroff. "That, on top of energy costs, is feeding expectations of a slowdown" next year.

A cold snap this winter could revive energy prices and could again lift inflation expectations, he says.

Falling bond yields initially helped stocks. But after trading as high as 10,741.99 intraday, the

Dow Jones Industrial Average

closed down 0.1% at 10,741.99. The Dow was dragged lower by a 4.8% loss in

General Motors

(GM) - Get Free Report

, as investors appear increasingly worried about the carmaker's liquidity. A 3.8% gain in

Johnson & Johnson

(JNJ) - Get Free Report

helped the index avoid wider losses.


S&P 500

fell 0.4% to 1229.01 and the

Nasdaq Composite

fell 0.65% to 2186.74.

Among other stocks in the news,

(AMZN) - Get Free Report

rose 4.5% after news that it will join the S&P 500, replacing


(T) - Get Free Report



(GOOG) - Get Free Report

, which was seen as a strong candidate to fill the vacated spot on the S&P, fell 1%.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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