AT THIS POINT I'D

probably dislocate a shoulder if I tried to pat myself on the back for my terrific bear call on bonds which have gotten absolutely trashed as long-term interest rates have risen from 3.97% less than a month ago to over 4.5% this week. I have to be modest about this because I've been bearish on bonds for so long, you'd be justified in saying that I'm nothing but a broken clock that's right twice a day.

On the other hand, it would be equally fair to say "better late than never." All the realities I've been talking about in this column for so long have finally begun to catch up with the bond market. By the way, I'm not the only one who has waited impatiently for this day of reckoning. As recently as a month ago Alan Greenspan called low bond yields a "conundrum" and an "aberration."

Why have bond yields stayed so low and bond prices so high for so long? And what's different all of a sudden?

I think the answer can be summed up in one word: inflation. It's not just that investors have forgotten about the ravenous beast that did so much damage to our economy and our markets in the 1970s and 1980s. More than that, it's that there are some unique things going on in the world that have convinced investors falsely convinced, I should say that inflation cannot possibly be a threat now. But make no mistake: It is a threat.

Investors have been making a mistake about inflation not because they're stupid. Actually, it's because they're too clever. They are sagely detecting a quantum shift in the U.S. economy toward immensely higher productivity. PCs... the Internet... just-in-time logistics... and most of all, cheap labor from China and India it really is a new world now, in which we can produce goods and services at lower prices. How can inflation be a threat?

Simple, and here's where investors have been too clever: They've forgotten that falling prices doesn't necessarily mean there's no inflation. You can have falling prices and inflation at the same time. In fact, I'm convinced that's just what's going on.

It sounds counterintuitive, but remember one basic principle and you won't go wrong. Prices rise and fall for many reasons. But inflation is involved in those price changes only when the value of money itself changes.

Keep in mind that the price of a good is really that good's "exchange rate" for the currency in which it is priced. If apples are priced at 50 cents apiece, that means it costs one dollar to buy two apples or, just as true, it costs one apple to buy half a dollar. That exchange rate can change for two reasons: Either something happens to apples, or something happens to the dollar. If it's the dollar that something happens to, then it's inflation.

Now here's where it gets complicated. Suppose something happens to apples and to the dollar at the same time?

Suppose we suddenly start getting all our apples from China and India, where labor is cheaper. If we knew for sure that the dollar was rock-steady, then we'd expect the price of apples to go down. Let's say labor is so cheap there that the price of apples would fall by half, to only 25 cents each.

But suppose at the very same time that the dollar is not rock-steady. Let's say the Federal Reserve goes on an inflationary binge and effectively prints money around the clock, doubling the amount in circulation. If it weren't for the cheap labor in China and India, 50-cent apples would inflate to $1 each. But thanks to that labor, 25-cent apples inflate to 50-cent apples.

In my exaggerated example, the productivity gains from cheap labor are perfectly counteracted by inflation losses. Apples started at 50 cents, and they ended up at 50 cents. But does that mean there was no inflation? Hardly! There was a huge inflation. The result of it is that apples that should be selling for 25 cents are still selling at 50 cents.

That's what's happening in a smaller way throughout our whole economy. American consumers should be enjoying a bonanza of falling prices thanks to cheap labor in China and India. But it's all being inflated away in other areas of the economy, because the Fed has kept interest rates too low for too long. The price of the basic necessities of life gasoline, food, building materials, housing are soaring. The rate of inflation reported by the core Consumer Price Index has more than doubled since year-end 2003, despite the falling prices of t-shirts made in China sold at Wal-Mart Stores.

Bond prices are very sensitive to inflation, because bond holders are concerned with the purchasing power of the money they get paid when their bonds mature. Maybe bond holders have been comforted by the idea that cheap labor from China and India will increase their purchasing power. But that's a real mistake. Bonds don't get redeemed for t-shirts they get redeemed for money. And while t-shirts may be getting cheaper, the value of money is being inflated away at the same time.

When your 10-year Treasury bond matures in a decade, will it really matter that t-shirts won't cost you any more than they do today when the price of oil has doubled? When the price of a hamburger has doubled? When the cost of a new home has doubled?

And remember, if it weren't for inflation, that t-shirt wouldn't cost you the same 10 years from now as it does today. It would cost half the price, thanks to cheap labor.

That's really adding insult to injury. It's hard enough for the American economy to adjust to losing basic manufacturing jobs to overseas laborers. But shouldn't American consumers at least get the benefit of falling prices, without having them inflated away?

In a nutshell, the productivity miracle arising from technology and global labor markets is leading to lower prices. But those lower prices are being masked by inflation.

At the same time, those lower prices are themselves masking the true extent of the inflation. It's a dangerous combination of deceptions.

It seems like the bond market is finally beginning to see through the masks with soaring oil prices and higher-than-expected inflation statistics making the truth pretty unmistakable. Now that the "conundrum" and the "aberration" of low bond yields has begun to resolve itself, perhaps Alan Greenspan will be moved to raise interest rates rapidly enough to stop the inflationary impulses that bonds are finally beginning to fear.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com.