Pointing to trouble: rising interest rates take a toll on business as fed fights off inflation.

WHEN Federal Reserve Chairman Ben Bernanke sounded the alarm about inflation this month, the financial markets went into meltdown mode.

The prospect of a 17th consecutive rise in interest rates was enough to send every major market index into negative territory. Within weeks, investors watched all their market gains this year evaporate into thin air. And more bad news could be just around the corner.

High energy prices, a weak dollar and an increase in the consumer price index have all strengthened expectations that the Fed will raise the current federal funds rate, the interest that banks charge each other, to 5.25 percent when it meets later this week.

Of course, Wall Street analysts had been hoping the Fed had ended its two-year string of rate increases. If the U.S. economy does not slow from the 5.3 percent growth it showed in the first quarter, the central bank is expected to hike rates again later this year, perhaps twice, to 5.75 percent.

These developments are bad news for consumers and businesses as they've already been digging deep into their pockets to pay for an 18 percent jump in energy prices for the past year. Analysts fear that as long as crude oil futures trade above $70 a barrel, as they have for the past two months, they will continue to push prices for other goods and services higher as well.

"We know that inflation can have a great deal of inertia and we have to be very diligent and very careful to make sure that doesn't happen," he said.

Federal Reserve Governor Susan Bies has been quick to point out that the Fed's favorite inflation gauge--the core personal consumption expenditures index--has crept above 2 percent. That is considered outside the central bank's so-called "comfort zone."

The problem is that Fed rate hikes send a chill through the economy by raising the cost of borrowing. Consumers will end up paying more for everything from adjustable rate home mortgages to auto loans, pushing some companies into troubled territory. The prime rate, which is the benchmark for most consumer and business loans, hit a critical five-year high of 8 percent, and is likely to begin cooling the hot housing sector, and other sectors are expected to follow.

While just about everyone is certain that rates are going up, there is no real consensus on a number of questions, including:

* What kinds of lending strategies are banks and mortgage companies adopting that will allow them to maximize returns without bankrupting borrowers?

* How does a small Los Angeles County business take cover? Is anyone going to make out in the market during this period? Who's most vulnerable, and does anyone going to make a killing?

* Are there lessons to be learned from similar scenarios in the past? How is this situation to the months before the dot-corn bust or a decade ago, when Orange County went bankrupt?"

We've talked to the experts and, while no one's claiming to have all the answers, there is plenty worth knowing.

Staying Ahead

The increase in Federal Funds rate has steady risen while the
rise in inflation has fluctuated over the past 11 months.

JUNE 2005 MAY 2006

Inflation Increase   Federal Funds Rate

      2.53%                3.75%
      3.64%                4.0%
      4.35%                4.25%
      3.42%                4.5%
      3.99%                4.75%
      3.36%                5.0%
      4.17%

Note: Table made from bar graph.