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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) - Get Goldman Sachs Group, Inc. Report

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) 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.

They point to the Labor Department's national employment statistics, which showed the fourth straight monthly decline in the U.S. job market in April. Wage growth has been weak for years, in sharp contrast to the wage spikes that underpinned the last outbreak of inflation in the U.S. in the 1970s.

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The forces that are weighing on U.S. wages, though, did not exist in the 1970s -- namely, the addition of a huge portion of the world's population into the labor market with the introduction of emerging economies like China and India to the global economy. Moreover, labor unions have much less clout in the U.S. than they did in the 1970s, and wages for lower-income workers haven't kept pace with the rising cost of living.

So this time around, the forces of inflation may be less likely to show up in wage growth, but that hardly provides comfort to consumers as food and energy prices rise and the value of their income and savings declines with the plunge in the value of the dollar.

Credit Conditions Better, But Not Good

Meanwhile, even as the Fed finds innovative ways to inject liquidity into the still-fragile credit markets to reassure investors, interest rates aren't fully cooperating with the central bank. Libor, a key benchmark for borrowing costs in the banking system, remains elevated far above historical norms, suggesting that jitters in the credit markets remain and banks aren't comfortable with the low level of the Fed's target for its federal funds rate.

Libor, or the London Interbank Offered Rate, is calculated daily by the British Bankers' Association (BBA). Adjustable rate loans are benchmarked to Libor, so monthly interest payments for borrowers all over the world are determined by its fluctuations.

On Wednesday, the three-month Libor rate was calculated at 2.76%. That's a significant premium to the fed funds rate target of 2%. It's also a large spread over the 1.68% yield on the three-month U.S. Treasury bill, which represents a rate that's free from the market's concerns about banks' financial health because it's backed by the U.S. government.

Recently, the spread between Libor and the yield on a three-month Treasury bill was 1.08 percentage points. That's a far cry from the 1.58 percentage-point spread in mid-April, suggesting that banks are becoming more comfortable lending to each other. That said, in the five years before the credit crisis began, the spread averaged a mere 0.28 percentage points.

"It's clear that there's still a huge amount of dislocation in the interbank lending market, and there's going to be a period of time before banks get truly comfortable lending to each other," says Daniel Alpert, a managing director with Westwood Capital. "Every bank is concerned about what's in other people's closets because they know what's in their closets."

To make matters worse, speculation is growing on Wall Street that Libor is artificially low. The rate comes from data compiled daily by the BBA that is supplied by banks all over the world. Observers suspect that banks may be unwilling to report their true cost of interbank borrowing for fear of revealing the full extent of their liquidity problems and becoming the next

Bear Stearns

( BSC). The firm, crushed by rumors it was becoming insolvent, was bought by

JPMorgan Chase

(JPM) - Get JPMorgan Chase & Co. Report

for $2 a share in March, with aid from the Fed. JPMorgan later increased its offer to $10 a share.

In mid-April, Libor surged by 0.08 percentage points in one day after BBA, amid heavy scrutiny, announced it was speeding up a probe into the accuracy of its information from banks. More recently, a London-based broker-dealer with offices in New York called


announced plans to launch a new, U.S.-focused measure of interbank lending rates. Citigroup interest-rate strategist Scott Peng has proposed the creation of a "NYbor" index, which would track the borrowing costs of U.S. banks only because problems for European banks are viewed as having an outsized effect on borrowing costs in the U.S.

At any rate, markets are having trouble swallowing the Fed's easy-money policies -- little wonder, considering that record-low interest rates earlier this decade orchestrated by Bernanke's predecessor, Alan Greenspan, are widely blamed as a root cause of the housing bubble to begin with.

"When the history of this period is written, it will turn out that we had negative interest rates -- a fed funds rate below the rate of inflation -- for the majority of this decade," says Alpert. "The only time the Fed tried to put rates back where they should be in 2004 and 2005, it blew up in their faces. There's something very wrong when you have a situation where the U.S. economy will crater unless interest rates are brought artificially low."

One way or another, the low-rate environment can't last forever.

"Rates will have to go higher, because people who have money and who are interested in investing are realizing they made loans at way too low an interest rate in terms of the risk they were taking," says Anthony Downes, a senior fellow with the Brookings Institute. "They're going to demand higher interest rates."

With the recent proliferation in floating-rate debt outstanding in the U.S. economy, higher interest rates will mean higher borrowing costs for countless consumers paying off mortgages, student loans and credit card debt. That will be an added drag on economy.

Fannie Mae

( FNM) and

Freddie Mac

( FRE) alone are holding trillions in consumer debt on floating-rate mortgage loans, and the federal government is currently expanding their role in the mortgage market. Add to that the $500 trillion in derivatives contracts held by companies and financial institutions that are based on Libor.

"This is a situation that did not exist when the Fed had to raise interest rates dramatically in the early 1980s, and we haven't seen yet what the economic costs of it will be when rates go up," says Josh Rosner, analyst with Graham Fischer & Co. "We are headed for a higher interest-rate environment."