This conundrum is bedeviling today's stock market: If the

Federal Reserve

hikes rates, it's bad news for stocks. If the Fed doesn't hike rates, it could be worse news.

A growing minority of Wall Street investors thinks the Fed could be on the verge of letting inflation spin out of control. And that possibility gives credibility to fears about a repeat of 1994. That year, the Fed went on a rate-hike rampage, doubling interest rates through seven rate hikes that ended with a huge, three-quarters-of-a-percentage-point jump in November 1994.

Fed inaction in June could add to investor jitters. In a stock market driven by worries and emotions, that would be a big negative.

Rate-hike fans see a dark scenario unfolding if the Fed doesn't move. Their fears can be summed up like this: The Fed has kept its attention focused for too long on deflation and on the danger that falling prices would choke off business investment and stall the economy. The latest May 4 statement from the Federal Open Markets Committee, its policymaking arm, still calls the dangers of deflation and inflation about even: "The risks to the goal of price stability have moved into balance."

Inflation worrywarts say that this ignores evidence that inflation has increased, and that further increases are building. They say the Fed has only a limited time to act before expectations of future inflation get embedded in the economy and in consumer and business behavior. Once that happens, history shows, it takes more than a few 25-basis-point rate hikes to stamp out that inflationary psychology. Which is why, these investors say, the financial markets should worry about a replay of 1994 if the Fed doesn't act now.

This argument, of course, depends on the strength of the evidence that inflation is picking up.

Inflation Isn't Alarming So Far, but...

On the surface, the numbers don't seem to support a belief that inflation is about to come roaring back.

According to the April consumer price index, or CPI, reported May 14, inflation for the month looked mild indeed. With a 0.2% rise in the CPI, inflation is now running at 2.3% year over year. That certainly isn't alarming.

Go deeper into the numbers, however, and there's just enough in the trends to make the "inflation is stronger than the Fed thinks" argument seem plausible. That 2.3% year-to-year rate is up from 1.7% last month. That fuels the argument that the rate of increase is rising.

And the core CPI, which measures inflation after subtracting the effects of volatile energy and food prices, rose 0.3% in the month. It's now running at a 1.8% year-on-year rate. Annualizing the core inflation for the last three months, however, shows that it climbed at a 3.3% rate. So it sure looks like we've seen the end of a downward trend in core inflation that took the rate down to a 40-year low of 1.1% for the November 2003 to January 2004 period.

The April numbers aren't isolated data points. The March readings, which also showed only mild inflation at first glance, revealed the same deeper inflationary tendency. The CPI was up just 1.6% year over year, but up 5.1% if you annualized the trend for the first three months of the year.

The volatile food and energy components were just that: volatile. Food prices were up 3.2% year to year in March, and energy prices were up 38% if you annualize the three-month trend. I certainly don't expect energy costs to rise at that short-term pace over a full year, but energy prices did climb 6.9% in 2003.

Economists like to take energy and food prices out of the CPI because those prices can jump around so much month to month. That practice, though, seems to ignore the way today's food and energy prices work their way through the economy to become tomorrow's prices for airline tickets, electricity, steel and plastics. Last week,

Wal-Mart

(WMT) - Get Report

told Wall Street analysts that increases in gas prices were taking more than $7 a week from the typical Wal-Mart customer's disposable income. That's real inflation in my book.

In fact, working backward in the economy from the prices that consumers pay to those charged at the wholesale level and at the producer's level shows that inflation in general may be working its way down the pipeline.

Pressures Are Building

Let's look at the April producer price index (also known as the PPI) report, which came out May 13.

The index climbed by an unexpectedly large 0.7%, way above the 0.4% consensus estimate of economists. That puts the year-on-year rate of increase at 3.7%. (The core rate, minus energy and food, was 1.6%.) There's always inflationary potential when the PPI is climbing faster than the CPI. The discrepancy often signals that price pressures are building up in the economic pipeline but aren't yet being felt at the consumer level.

And you can certainly see evidence of inflationary pressures in the pipeline by looking at the price increases that the PPI measures at different points in the production process. Compare the 1.6% increase in the core index for finished goods with the core price increases for goods at the intermediate, or wholesale, level at 4.2% year over year. And the core price increases at the intermediate level are lagging even further behind the 26% year-over-year increase in core prices at the crude or raw-materials level.

Companies Eat Price Increases

This huge discrepancy in inflation at the consumer, wholesale and raw-materials levels has persisted for months now. Companies that sell to consumers have been eating price increases rather than passing them to customers, out of a fear they will lose market share. And inflation at the raw-materials level has been offset by cost cuts and gains in manufacturing efficiencies.

Three developments suggest that this period of stable consumer prices may be ending.

Consumer companies have announced price increases and then stuck to them.

Procter & Gamble

(PG) - Get Report

and

Kimberly-Clark

(KMB) - Get Report

announced increases in the prices of their paper goods in March. Those price increases are still scheduled to go into effect this summer. We're not talking about tiny 1% price increases, either. Here's what Kimberly-Clark said: "Prices for bathroom tissue, paper towels and napkins will be increased effective July 11, 2004, and facial tissue prices will rise effective Aug. 29, 2004. The increases are expected to average approximately 6%."

China is reporting an uptick in its own inflation.

This may seem strange because China has produced much of the deflation in the prices of manufactured goods. It's uncertain exactly how much of an inflation uptick China is experiencing. The official Chinese position is that inflation now runs at 3% a year. That would be more believable if 3% weren't also the official inflation ceiling established by the Chinese government. Morgan Stanley estimates that the true inflation rate could be as high as 8%. China, which had been exporting deflation to the U.S., now looks like it will be exporting inflation.

Wal-Mart predicted minor inflation in the prices of general merchandise by the fourth quarter.

Pay attention to what Wal-Mart says. It accounts for 8% of all U.S. retail sales, excluding auto sales. I'd say it has more influence on U.S. inflation right now than Alan Greenspan and the Fed.

Wall Street, after listening to the company's most recent update, is predicting better margin control. That's Street-speak, I think, for Wal-Mart keeping more of its savings by wringing lower prices from suppliers for itself and passing less of them on to consumers. In the first quarter, Wal-Mart's gross margins climbed 25 basis points thanks to savings from global outsourcing (read "buying more stuff from China") and improved sales of higher-margin clothing. But that wasn't enough to offset increases in health care costs, payroll and utilities.

Wal-Mart may still be set on being the cost-cutting leader in retailing, but it looks like the pace of those cost cuts is about to slow. And that would give more wiggle room for price increases to all of those companies that do big business with Wal-Mart.

This Is Not 1994

None of this adds up to a guarantee of inflation or solid evidence that the Fed has let inflation get so established that Alan Greenspan and company will have to increase interest rates faster than most investors now expect.

Even if inflation is established and the Fed has to play catch-up, that doesn't mean we're in for a replay of the 1994 scenario. Such a replay is unlikely. In 1994, the Fed's move to raise rates caught the stock and bond markets by surprise, and no one can argue that this time the Fed hasn't telegraphed its intentions repeatedly. And the deflationary trend of the prices of global manufactured goods -- even if China is starting to experience its own inflation -- is an important damper on inflation at the consumer level that didn't exist in 1994. Given the current global economy, it's hard to see how U.S. inflation could zoom ahead so strongly in the short term to necessitate a quick 3-percentage-point increase in short-interest rates like the Fed engineered in 1994.

Still, this argument doesn't have to be right to have a negative effect on stock and bond markets. It only has to be emotionally convincing enough to shift a significant number of investors from buyers or holders to sellers. The impact of events like the continued war in Iraq, surging oil prices, and uncertainty about the direction of Chinese economic policy have made this an emotionally fragile market. It's vulnerable to overreaction on inflation evidence of the sort I've just presented. Every bit of evidence that argues for a return of inflation that accumulates without a response by the Fed just adds fuel to fears that the Fed lacks the will to fight inflation.

The financial markets might not like an interest-rate hike at the end of June, but because that increase is pretty much already priced into stocks and bonds, a swig of bad-tasting preventive medicine might be the best thing the doctor can deliver.

Otherwise, an already nervous patient is likely to toss and fret, imagining that the sickness is getting worse and that the ultimate treatment will have to be unpleasant indeed when it is finally administered.

At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. Email Jubak at

jjmail@microsoft.com.