In 1997, Gary Kasparov, then the world's long-reigning chess champion, was finally beaten -- by an

IBM

(IBM) - Get Report

computer of enormous power. Thereafter, the chess genius's career went into decline.

Now,

Alan Greenspan, the world's most successful central banker, with an intellect and reputation to match that of the mighty Kasparov, could soon face defeat by the beast that

he

has been trying to hold in check for 13 years: the U.S. economy.

Investors, who have bet that Greenspan can keep the economy chugging along at a sustainable rate, are worried that this grandmaster's luck may be up after a key price index, released Friday, rose by far more than expected. And the

Nasdaq

dropped 6% and the

Dow

shed more than 1% amid news of U.S. air strikes against Iraq.

Why is Wall Street panicking? The 1.1% jump in the

producer price index for January raises the possibility that the

Fed chairman is now facing a scenario that all central banks dread: inflation rising as the economy slows. When this happens, a central bank's hands are tied. The threat of inflation prevents it from cutting interest rates, the action it would normally take to boost growth. As a result, it must let a recession run its natural course. The Fed has reduced its key

fed funds target twice already in 2001 -- by half a percentage point on both occasions -- because it fears that a slowdown is under way.

Stag Party

Investors had come to accept that a slowing would take place and that it would be shallow and short-lived. Of course, they understood that the deceleration was going to hurt company profits, but the stock market moves on perceptions of the future. And as long as a recovery could be expected in the latter part of 2001 or perhaps 2002, investors were happy to hold stocks.

To be sure, that balanced recovery may come. Greenspan may still bring everything back to equilibrium. Most economists expect better economic growth after a couple of quarters of sluggishness. The buoyancy implied by the high PPI indeed suggests that the economy is rebounding. It could even be returning to its famed Goldilocks state -- not too hot and not too cold -- witnessed in the '90s.

Then there's the argument that the big rise in the PPI is a flash in the pan caused by extraordinary factors. High energy prices were a big contributor. True, excluding those, the so-called core PPI leaped a higher-than-expected 0.7%. But that, too, was due to possibly one-off increases -- in tobacco and car prices -- economists are noting. As a result, to worry about inflation at this point is absurd, they argue. And Friday's bond market action suggests that fixed income investors have zero concern that inflation is back. Treasuries rose in price, which implies that traders believe the Fed will keep interest rates where they are or continue to cut them.

"I think this is a temporary increase" in the PPI, says Dick Berner, U.S. economist at

Morgan Stanley

, whose economics research team is expecting a recession in 2001. "The PPI is a very volatile statistic. The Fed looks more closely at the CPI," or

consumer price index. Moreover, since so many other indicators -- like commodity prices, consumer confidence and output measures -- are showing economic softness, the PPI could easily be an anomaly.

Stop the Presses!

So why be worried that the Fed is in a catch 22 and that inflation could suddenly be rearing its ugly head? Inflation is created by too much money chasing too few goods. And it's easy to make the case that the Fed has been printing too much money. One measure of money supplied, called M2, is soaring.

Bianco Research

, a bond and economic analysis firm, Friday calculated M2's 13-week growth rate to be 12%, the highest rate since 1998, when the Fed flooded the economy with liquidity to offset the shocks to the financial markets caused by the Russian ruble devaluation and the near collapse of the giant hedge fund

Long Term Capital Management

.

"Money supply is going to the moon," comments Paul Kasriel, an economist at

Northern Trust

who has been

skeptical about forecasts of a sharp economic slowdown. It was the high 1998 spike in money supply that caused inflationary pressures that the Fed had to fight with sharply higher rates in 1999.

Many in the economics trade have come to believe that adding extra money to the New Economy shouldn't cause inflation, because productivity rates are currently so healthy (productivity measures output per hour). The theory goes that companies should be able to meet all the extra demand created by the extra money without having to push up prices.

But that can happen only when companies' costs don't go up too fast. If they do, they can either try to pass them on, which may be the cause of inflation numbers like the PPI today, or they can cut back and lay people off, a la

Nortel

(NT)

,

Dell

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and

GM

(GM) - Get Report

. The problem is that the cutbacks, while dramatic to behold after years of low unemployment, may represent a small and partial unwinding of the massive capacity build-out carried out recently in the U.S.

Capital Idea

In fact, as long as the Fed prints money, companies will think demand is stronger than it really is. Therefore, they will, on average, continue to employ too many people and spend too much on capital. But if they do that, they will inevitably compete in a tight market for workers and capital -- and the costs of those will keep rising and have to be passed on as inflation if profits aren't going to plunge. This can partly be seen in the numbers. Kasriel points out that nonfarm business compensation is growing at over 5%, well above recent historic levels.

The energy sector boldly illustrates the supply-side problems that could be pushing up the PPI. And since the energy sector isn't going to solve its supply issues quickly -- it takes a while to build power generation capacity, and there are huge lines for key equipment like

GE's

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generation turbines -- it makes little sense to treat energy prices as a noncore part of the index. The energy element of the PPI rose a torrid 3.8% in January -- and it's been rising faster than the index as a whole for a long time. Utilities are utilizing over 90% of their capacity, a much higher usage than other sectors. Supply hasn't been keeping up with demand -- regardless of all the Fed has done through monetary policy.

Sean Corrigan, of

Capital Insight

, a Rochester, England-based research firm, sums up the supply constraints like this: "The Fed can print all the money it likes but it can't print natural gas." Corrigan accepts that the latest PPI reading may be a rogue number, but he also notes that more hawkish members of the Fed, who have given recent rate cuts half-hearted support, may be emboldened by this number.

Quite possibly, there may not be any more high inflationary data for a while. But the Fed's current loosening could cause a barrage of white-hot numbers in the not-too-distant future, says Kasriel. "If Greenspan keeps printing money like this, people are going to be talking about raising rates in the fourth quarter," the economist says. "We're getting close to checkmate." Greenspan may have met his Deep Blue.