As if there weren't enough problems, now there's inflation to consider.

With this morning's surprisingly strong showing in the

Consumer Price Index for January, investors are concerned that inflation fears could derail the

Federal Reserve from its current track of getting the economy back in growth mode. The thinking is that

this CPI report, along with the hefty jump in last week's

Producer Price Index, may tie the Fed's hands because of fears about stagflation -- that nasty combination of rising prices and slowing economic growth.

While fears of inflation are growing, by and large economists believe costs at the consumer level are not spinning out of control. The CPI rose 0.6% in January, double the 0.3% rate expected by economists. The core rate, which excludes volatile food and energy prices, rose 0.3%, also higher than the expected increase. Certain key price measures, such as energy, tobacco, medical and housing costs, are showing steady increases. But the overall core year-over-year inflation rate is currently 2.6%. That's about where it's been for the last six months. Still, it doesn't look good when compared to Jan. 2000, when the core CPI was rising at only a 2.0% rate.

The CPI is the market's best measure of inflation at the consumer level. On a year-over-year basis, the overall CPI -- which includes energy and food prices -- is rising at a 3.7% rate. That's highest reading since July.

But because the rate hasn't spiked wildly out of control, economists aren't yet waving any red flags. "The truth is, the increases in the core rate are running at about 0.2% per month, basically what it's been doing," said Brian Jones, economist at

Salomon Smith Barney

. "People have to keep their eye on the ball here. The Fed is easing. They're easing because the economy slowed appreciably in the second part of last year, and the evidence we have to date is not enough to stay their hand."

So inflation in general has been ticking up, albeit slowly, in most areas of goods and services. But there are a few reasons why this report most likely won't change the Fed's stance towards defending the economy against a recession. First, one month does not a trend make, especially when the core rate of inflation is the same as the previous month.


Consumer Prices Rise

Source: Department of Labor

And the general expectation in the market is for more sluggish growth, so prices can be expected to follow south. Consumer confidence has been waning. As the economy slows, individuals aren't likely to be willing to pay even more than they do now for most goods and services. "You would assume that the slowdown in economic activity would take care of any lingering price pressures over next several months," said Anthony Karydakis, senior financial economist at

Banc One Capital Markets

.

Since it doesn't immediately signal the current state of demand, the CPI can be a bit of a lagging indicator as far as how the whole economy is viewed. If demand continues to slide, it makes sense to expect that prices would come down. That's why next week's scheduled reports on

durable goods orders and the

National Association of Purchasing Management's

purchasing managers' index are important. In recent months, both have been showing weakening consumer and corporate demand, which ultimately affects prices.

The Fed's statement at the conclusion of its most recent meeting on Jan. 31 makes clear where the monetary policy making body's intentions lie. After cutting interest rates by a half percentage point for the second time in a month, the Fed said that "with inflation contained, these circumstances have called for a rapid and forceful response of monetary policy." Lower rates, after all, make it cheaper for both consumers and companies to borrow money. Rate cuts tend to lead to economic growth several months down the road.

The

fed funds futures market, the best indication of what kind of odds the market is placing on future interest rate cuts from the Fed, shows that traders aren't taking this morning's CPI report as a harbinger the Fed will back off from easing rates. The March federal funds contract is placing a 95% chance that the Fed will cut rates by an additional half a percentage point, compared with 87% chance yesterday. Still, the bond market is slipping today. Longer-term bonds are selling and yields are rising based on expectations inflation will continue to increase. Shorter-term Treasuries aren't moving higher, and they move in synch with expectations about Fed policy.

Still, Plenty to Worry About Here

The worrisome aspects of this report can't be dismissed, however. Rising health care and shelter costs show that cost increases aren't confined to energy, although the largest increase in costs are still fuel-related. The index for natural gas increased 17.4% in January and has advanced 59.3% in the last 12 months. Home heating costs are continuing to rise consistently. The other problematic areas are in medical costs, which rose 0.6% in January and are up a significant 4.5% on a year-over-year basis. The shelter component, which measures housing costs without energy prices factored in, rose 0.3% during the month and is up 3.3% on a year-over-year basis, reflective of ongoing strength in the housing market.

"Numbers like this would encourage the Fed to go a little slower," said David Greenlaw, chief U.S. fixed income economist at

Morgan Stanley Dean Witter

. "The market is going to have to adjust to a slower timetable as far as easing goes."

Over the next few months, economists expect the prices of clothing, automobiles and computers will keep overall costs down. We know that computer prices are always declining, but manufacturers and retailers now have added incentive to keep pricetags attractive if they hope to encourage more purchasing.

Overall, the picture is mixed. Jones points out that at least one CPI report every year tends to show unusual gains, such as in March 2000, when the overall CPI rose 0.7%. That report was one of the factors that motivated the Fed to raise interest rates by 50 basis points to 6.5% last May. That increase, in retrospect, now seems overzealous. And Jones doesn't think the Fed will alter its thinking based on today's CPI report.

But if a growing number of higher costs do stick, then things are going to get stickier -- for the Fed and the entire economy.