Updated from 11:19 AM

SAN FRANCISCO -- There was something for everyone involved in the inflation debate this morning, highlighted by testimony from

Federal Reserve

Chairman

Alan Greenspan

.

The

Consumer Price Index

rose 0.2% in June, the

Labor Department

reported this morning. The core rate, which excludes food and energy, rose 0.3%. Both figures exceeded economists' expectations for a rise of 0.1% overall and a 0.2% gain in the core. Year-over-year, CPI is now up 3.2%, down from 3.4% as of May, while the core is up 2.8%, the highest reading since February.

A 0.9% drop in energy prices provided the biggest downward drag on the CPI last month. Given expectations that increases in fuel and utilities costs in the housing component "won't stand," market players are convinced CPI inflation will be headed lower in the coming months, said Anthony Crescenzi, chief bond market strategist at

Miller Tabak

. Housing is 40% of the CPI.

More importantly, perhaps, Greenspan said not to be alarmed about the CPI report in his

semiannual monetary policy report to

Congress

today.

While CPI inflation has increased this year, the chairman noted it has not been matched by increases in other price measures, such as the index of core personal consumption expenditure prices. To critics, Greenspan is being coy by focusing on the data that most supports his oft-stated view that inflation is contained, which he reiterated today.

Still, he acknowledged "it is difficult to judge whether long-term rates have held up

despite 275 basis points of easing this year because of firming inflation expectations or a belief that economic growth is likely to strengthen, spurring a rise in real long-term rates."

Finally, the chairman reiterated the central bank's "vigilance against inflation," calling it "more than a monetary policy cliche," but "the way we fulfill our ultimate mandate to promote maximum sustainable growth."

Essentially, he reaffirmed longstanding themes that the economy will likely improve by the end of the year and that inflation remains under control.

The knee-jerk reaction to the testimony was that Greenspan is leaving open the possibility of more rate cuts going forward. Fed funds futures are pricing in an 86% likelihood of a 25-basis point ease at the Aug. 21 meeting.

"We may need to ease further," the chairman said, "but we must not lose sight of the prerequisite of longer-run price stability for realizing the economy's full growth potential over time."

That line got traders thinking the Fed has "shifted gears from a proactive to a reactive stance," Crescenzi commented.

Notably, the long end of the Treasury bond market -- which is most inflation sensitive -- was rallying more sharply than the short end. Lately, the price of the benchmark 10-year note was up 22/32s to 99 3/32s, its yield falling 5.12% while the 2-year note -- which is most sensitive to the direction of the fed funds rate -- was up 7/32s to 99 27/32s, its yield falling to 3.96%.

Still, Crescenzi reaffirmed a belief expressed here in

late May that the long-end of the Treasury market is experiencing just a "trading rally."

Problems in Argentina, falling energy prices, and the stock market's recent woes have contributed to the rally and made it "more sustainable than I imagined," Crescenzi conceded. "But I still believe

the rally is temporary. Bonds are very vulnerable to more signs of strength in the economy and optimism" about the economy.

However, the long bond and 10-year aren't vulnerable because of inflation expectations, he said; those are "heading down."

Meanwhile, the stock market was taking little solace from Greenspan's remarks, having resumed its downward path after a brief flicker of a rally when the chairman's testimony began.

Lately, the

Dow Jones Industrial Average

was down 0.8%, the

S&P 500

was off 1% and the

Nasdaq Composite

was down 2.6%.

Today's action provides a nice excuse to revisit the question posed

Monday night: If inflation is moribund, how to explain the performance of inflation-sensitive vehicles such as long-dated Treasury bonds, gold stocks and other economically sensitive issues?

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Several readers replied to the query, and a few even offered some cogent analysis. Among them was Jeff Bagley, a portfolio manager at

McCabe Capital Managers

in King of Prussia, Pa. McCabe Capital manages both equity and fixed-income portfolios with about $200 million under direct management.

In an email exchange, Bagley suggested "inflation won't be a problem anytime soon," for the following reasons:

Very low capacity utilization. "It has dropped like a rock."

Can't argue with that. Tuesday, the

Federal Reserve

reported industrial production fell 0.7% in June, the biggest decline since January and the ninth-consecutive monthly decline. Capacity utilization fell to 77%, the lowest level since Aug 1983.

On the other hand, Paul Kasriel, chief economist at

Northern Trust

in Chicago, issued a report yesterday debunking the idea that capacity utilization rates and inflation are linked. "There is effectively no relationship" between the two on a contemporaneous basis, and only a 0.22 correlation coefficient on a lagged basis, he concluded.

Growth in the M2 monetary supply, by contrast, has a 0.66 correlation coefficient to inflation on a lagged basis, Kasriel noted. "The fact that M2 money supply growth has been on an upward trend in the past three years suggests that core inflation is likely to trend higher in the year ahead rather than lower."

Lower energy prices -- His "favorite."

No doubt about this one, and today's reports on higher-than-expected oil inventories are likely to keep the downward trend intact. Crude-oil futures are down 31.6% from their high of $37.40 on Sept. 18 while natural gas futures are down a whopping 70% from their Dec. 22 peak of $10.50.

A very strong dollar -- imports are very cheap.

Can't argue with that either, as the

U.S. Dollar Index

is up over 9% year-to-date. Still, a wavering of the dollar's strength -- due to a change in policy, geo-political developments, etc. -- is one scenario the inflation "hawks" are closely monitoring.

High business inventories.

I'll concede this point, but am unsure it's heading in the right direction for Bagley's argument. On Monday, the

Commerce Department

reported business inventories were flat in May, while sales rose 1.1%. That brought the inventory-to-sales ratio, a measure of how long it takes business to sell their wares, to the lowest level of the year.

Reasonably good fiscal discipline.

Once again, I'm not sure this is heading in the "right" direction.

"The outlook for the federal budget balance in coming years continues to darken,"

Goldman Sachs'

economic research group suggested in a recent report. "It now seems probable that the fiscal surplus will be below $200 billion each year through at least fiscal 2005."

Admittedly, Goldman's estimates are below those of the

Congressional Budget Office's

, and definitions of the surplus vary (usually depending on one's political affiliation). Nevertheless, the once-gaping surplus is being eroded by a combination of tax cuts and a slowing economy, which is hurting corporate profits and thus the level of their tax payments. Increased spending on defense (among other areas) would further delete the surplus.

"The Social Security surplus should escaped unscathed,

but the margin for error will be very thin," Goldman concluded.

The good news here is that -- rather than inflation risks -- concerns about the future of the surplus and a possible slowdown in the Treasury's buyback program may explain why long-term Treasury bonds haven't fared better this year.

"Surely, one reason long-term rates have held up is changed expectations in the Treasury market, as forecasts of the unified budget surplus were revised down, indicating that the supplies of outstanding marketable Treasury debt are unlikely to shrink as rapidly as previously anticipated," Greenspan testified this morning.

As for other inflation- and/or economic-sensitive areas, Bagley suggested transports have performed well because of hopes for greater demand and lower costs for energy costs -- but not because of expectations for economic recovery, which doesn't necessarily mean higher inflation, regardless.

Basic materials have done well, he said, "due to hopes of greater demand and higher commodity prices, which have for the most part been depressed."

The fund manager suggested the yield curve is the market's best measure of inflation expectations. The spread between long- and short-dated Treasury securities has widened sharply in the past year, although shrunk recently as inflation expectations have diminished. Similarly, Treasury Inflation Protected Securities (or TIPS) have fared very well this year, although their performance has

recently faded.

"You can look at gold, but I don't put much faith in this indicator," Bagley added.

Well, that's another point we disagree on, if only because the perception of gold as a barometer of inflationary pressures remains powerfully entrenched in the hearts and minds of most investors.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.