The municipal bond market last week withstood its biggest loss in 13 months. It hadn't dropped so sharply since its retreat just before the presidential election last year, and the latest setback went a long way toward convincing issuers, traders, and investors that 1993's great decline in long-term interest rates was over, finished, kaput.

This bearish conclusion that interest rates have touched bottom for this cycle may be overdone, and a number of leading economists remain steadfast in their view that bond yields will soon resume their downward course. In 1994, they predict, 30-year Treasury bonds will yield less than 5 1/2% and the Municipal Bond Index will yield less than 5%. But the argument is harder to make, and the reason is "legislated inflation."

Optimistic projections of bond yields may seem daffy on the heels of the big moves recently. The long T-bond yield soared 46 basis points to 6.24% on Nov. 5 from 5.78% on Oct. 1, and the yield-to-par call on the Municipal Bond Index jumped even more swiftly, to 5.92% on Nov. 5 from 5.33% on Oct. 15, an increase of 59 basis points. In the midst of such a tumble, only the brave think about new lows for bond yields.

Lower rates of inflation have been a big reason yields have descended this year, but evaluation of overall inflation is becoming more difficult because of government-mandated change, not economic activity.

As Paul Boltz, financial economist at T. Rowe Price, has pointed out, governments can cause prices to rise though legislation, and with healthcare payroll taxes and higher minimum wages likely in the near future, legislated inflation seems likely to become more important.

The bond market may see that importance this week. When the consumer price index is released on Wednesday, a new excise tax on gasoline may wipe out the seasonal adjustment for energy prices and make the rise in the CPI larger than it otherwise would be. It could cause bond prices to decline still more.

Evaluating legislated inflation won't be easy. The federal government may try to hide it just as it tried to hide, energy inflation in the 1970s and 1980s by inventing a core CPI that did not include food and energy prices. In addition, taxpayers are fighting government-mandated inflation - witness the victory of Christine Todd Whitman in New Jersey.

In short, legislated inflation is complex and will be difficult to evaluate, but it exists, and the bond market must assess it. It helps explain the recent climb in bond yields, and it makes it more difficult to be optimistic that the great 1993 decline in interest rates will resume.

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