JUST WHEN YOU

thought things couldn't possibly get any worse, they have.

Less than a week after a scary surge in wholesale prices rocked Wall Street, the Labor Department reported that retail prices also popped higher last month. Wednesday's news reinforced worries that inflation is a worry, along with recession.

Although economists downplayed the likelihood of stagflation the nightmarish coexistence of sluggish growth and rising prices investors rushed for the doors again. The Dow Jones Industrial Average dropped 204 points to 10526; the Nasdaq Composite finished down 49 points at 2268, near its two-year low; the broader Standard & Poor's 500 index closed at 1255, its worst level since October 1999. The most interest-rate-sensitive stocks in the retail, financial and basic-material sectors closed lower, as investors debated whether the latest price data would tie the Federal Reserve's hands in its efforts to revive the economy with lower interest rates.

What rattled investors was news that retail prices, as measured by the consumer price index (CPI), surged 0.6% in January after rising 0.2% in December, mainly because of a record 17.4% jump in natural-gas prices (which have since fallen) and a 2.6% rise in electricity costs. The increase the largest since a 0.6% spurt in March 2000 was double economists' consensus forecast.

Of course, the whole reason the more closely watched core CPI excludes such energy costs, along with food, is that they're inherently volatile. But even the core rate came in troublingly higher than expected. After gaining just 0.1% in December, the core CPI climbed 0.3% last month, surpassing Wall Street's forecast for a 0.2% gain. The core rate was boosted primarily by a 1.9% acceleration in tobacco prices, a 1% rise in cost of housing and a 0.6% climb in medical-care costs. "What's disturbing is the broad-based nature of the increase," says Lehman Brother senior economist Ethan Harris.

While a recession in the manufacturing sector has kept goods inflation near zero, there's been a worrisome upward creep in prices in the service sector, which has so far avoided the brunt of the economic slowdown. As medical, recreation, telephone and public-transportation services all headed north in January, service costs rose 0.9%. On a year-over-year basis, prices in the sector are now up 4.5%. "That's problematic because services have become an increasingly large component of expenditures," says David Ingram, an economist at West Chester, Pa.-based research firm Economy.com. In fact, the service sector now accounts for about 40% of gross domestic product.

Even more problematic, consumer prices seem to be accelerating just when economic growth is slowing. Over the past three months, the overall CPI has risen at a 4.2% annual rate, while the core CPI climbed at an annualized 2.9% pace. That compares with headline and core CPI gains of 3.4% and 2.6%, respectively, for all of last year. At the same time, GDP, which grew at a 5% pace in 2000, is probably now growing at an annual rate of 1% at best.

The combination or rising prices and slumping growth certainly wasn't what the Federal Reserve had in mind when it lowered its benchmark federal-funds rate by one-half of a percentage point last month, saying that the risks of recession outweighed those of inflation. "Certainly the sharp easing of monetary policy in January now looks like a more risky course of action than it did just a few weeks ago," notes Stephen Cecchetti, a professor of economics at Ohio State University and a former research director for the Federal Reserve Bank of New York.

Now some economists are questioning the widely held assumption that Fed policy makers will continue to cut interest rates probably by another half point at their next meeting. The increase in the core CPI "is not going to stop an easing if the economy continues to slow, but it may make the Fed think more carefully" about the size of its rate cut, says Pierre Ellis, managing director and senior economist at Decision Economics, a New York-based consulting firm. Ellis thinks the Fed may now consider lowering rates by just a quarter point at its March 20 meeting. And "the chance of no move is not zero anymore," he says.

Still, it seems premature to conclude that a one-month uptick in prices will alter policy that remains skewed toward fighting recession, not pre-empting inflation. As Harris points out, the Fed knows that changes in inflation tend to lag behind changes in economic growth by about one year. That's because wage pressures that build in a tight labor market don't immediately reverse when the economy begins to slow. At first, companies may try to pass these higher costs through to the consumer in order to protect profit margins. This process usually reverses as corporate layoffs pick up, demand slackens and companies start discounting products to dispose of backlog. In other words, the latest inflation numbers may be more a legacy of last year's 5% growth than a reflection of the current slowing.

Although the Fed was slow to loosen the money supply when this cycle last played out during the recession of 1990-91 circumstances are different today. In 1990, core retail prices also accelerated into the slowdown, peaking at 5.5% six months into the contraction. Fortunately, core inflation is now running at about half as fast as it was in 1990, so the Fed can afford to react much more quickly to the downturn, says Harris. "The issue for the Fed is growth and getting it back up to a rate that's close to potential," says Brian Jones, an economist at Salomon Smith Barney. "The game is on a different channel now."