Whoa! Inflation is ... declining?

This morning's

Consumer Price Index

, the market's broadest measure of inflation, was somewhat shocking, calming, and more than a little goofy all at once.

The CPI declined in August for the first time in 14 years. Declines in energy prices during the month were completely responsible, but those have since been reversed, as oil prices are back to post-Gulf War highs. Despite that, the core inflation rate -- that is, prices consumers pay for everything but food and energy -- has remained reasonably steady for six months now.

Because key inflation figures have remained under control and because other recent economic releases show that economic growth is slowing, the bond market has lowered its expectations of any more interest-rate hikes by the

Federal Reserve.

The stock market, meanwhile, seems more preoccupied with the danger associated with higher fuel costs than anything else.

Both the bond and stock markets rallied in August, in part, on the growing realization that the Fed, at least temporarily, was done raising interest rates. At its last two meetings, the Fed has keep interest rates unchanged. Rates now stand at 6.5%, up from 4.75% in June 1999 after a series of hikes intended to slow the thriving economy.

What's becoming harder for investors to swallow is that the Fed now seems to be backing off rate hikes because the economy is truly slowing -- and maybe too much, some fear. A slower economy, after all, means diminished sales and corporate profits, neither of which is good for stocks.

Yet the inflation bug is still firmly on the radar screen, in the form of oil. Today's CPI showed a decline in energy prices in August, but it's well known that energy prices have rocketed back in September.

The annual growth rate of the CPI edged down to 3.4% in August from 3.5% in July. With energy prices rebounding, it's expected to rise in September.

In August, the core CPI rose to 2.5%. Since March, that rate has vacillated between 2.2% and 2.5%, so it has stayed relatively stable.

The

Producer Price Index, meanwhile, a measure of costs at the producer level, fell to a 3.3% annual growth rate in August. It has been trending in the 4% range for the last six months because of high oil prices. Excluding food and energy, the rate is 1.5%.

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It was hoped that the increases in daily oil production recently undertaken by

OPEC

would cause energy prices to decline, but demand and bottlenecks at various stages of processing have prevented this. Higher fuel costs have apparently begun to cut into both consumer spending and business investment. Housing activity and purchases of cars have declined in recent months, for example, and the

National Association of Purchasing Management's

purchasing managers' index

shows a moderation in manufacturing activity.

Economists are concerned that higher fuel costs will persist, squeezing consumers. If energy prices don't snap back to a more reasonable level (considered to be about $25 a barrel, compared with the current $35 a barrel), consumers will likely cut back on spending -- or they could demand higher wages to keep pace with increased costs.

"Oil is a black cloud in that silver lining," said Josh Feinman, chief economist at

Deutsche Asset Management Americas

. "People start to say, 'I need to build that into my compensation to keep my purchasing power intact.' "

Oil aside, the bond market is adjusting its inflation expectations lower. Recently, Treasury notes with maturities of two years or less have begun rallying, while Treasuries with longer maturities are declining. This implies that bond investors expect continued economic growth, but have much lower expectations of a Fed rate hike. (Short-dated Treasuries react most directly to Fed expectations, while long-dated Treasuries reflect the market's assumptions about growth.)

TSC

discussed this action in a recent

piece.

However, the pundit chatter that's been bandied about a bit in regards to a potential Fed rate cut seems overblown. More likely, the Fed is on hold for a while, economists say.

Corporate profits, however, could continue to suffer, squeezed by higher fuel costs on one side and diminished spending and demand on the other. Perhaps in a year or so, the market may look back and marvel at the soft landing that was achieved, but they may be conveniently forgetting that there could be some bumps and bruises incurred along the way.