A mild inflation report Wednesday set off a relief rally in bank stocks, but further complicated the interest rate picture two weeks before the Federal Reserve's next policy meeting.

The consumer price index was flat in May, the government said, reversing a big energy-led price spike in April that sparked a month of investor nervousness and subtle warnings from Fed officials that higher rates could well be coming.

With investors back in action, the Standard & Poor's bank index advanced 2.7% and the Nasdaq banks 0.68%. At the same time, the blue-chip Dow Jones industrial average was up 189.96 points, or 1.8%, to 10,784.95, while the broad-market S&P 500 index climbed 29.25 points, or 2.25%, to 1,330.41.

Major banks led the way. Chase Manhattan Corp. shares surged $5.25, or 7%, to $80.375. Citigroup was up $2.065, or 4.7%, to $45.875. And J.P. Morgan & Co. was up $6, or 4.7%, to $134.

But the latest data left observers divided about the central bank's probable course at its meeting June 29-30. Today attention will be riveted on Fed Chairman Alan Greenspan's expected testimony to Congress about the economy.

"Clearly, there is now a substantial element of doubt" about the Fed, according to Ian Shepherdson of High Frequency Economics in Valhalla, N.Y. While the "obvious message" of the new data is that the 0.7% jump in April's consumer price index "was a fluke," he said, the latest Fed Beige Book data reveals upward wage pressures that may presage a rate hike.

Indeed, several economists think a Fed rate hike is likely because of the economy's ongoing strength, as shown by other indicators released Wednesday. Housing activity rebounded from a relatively weak April. Industrial production and real wages registered respectable gains.

Wednesday's rally in stocks and bonds, they said, reflected a market perception from the benign consumer price index that Fed rate increases will be limited and may already have been fully discounted by investors.

"The bond market has already tightened (credit conditions) far more than the Fed could have been expected to," Merrill Lynch & Co. chief economist Bruce Steinberg told clients earlier this week.

The impact of higher market rates is clear in the mortgage sector. The Mortgage Bankers Association's survey showed that mortgage applications rose just 2.8% last week over the prior week but was down 2.9% from a year earlier. Refinancing activity fell 7.4% and is 41.9% below a year earlier.

As Mr. Steinberg saw things Wednesday, "the complete lack of inflation puts the Fed in a bind. Recent remarks by Fed officials make it seem they are hell-bent on tightening, but there is not much rationale from the recent data."

Besides dormant inflation, job growth is clearly slowing. "The pace of new payroll creation is now running 20% less than last year and that will eventually show up in consumer spending," he said.

Mr. Steinberg said Merrill Lynch's proprietary Fed reaction economic model is still in neutral after the latest consumer price index report, but remains the highest since the Fed last tightened credit in March 1997.

The Merrill Lynch economist termed inflation right now "the phantom menace" and does not think a Fed rate hike is needed. But he did not rule one out at the end of the month.

Others take a very different view.

Economists at Banc of America Securities this week urged the Fed to lift rates and resume "its macroeconomic mission of maintaining a noninflationary backdrop for economic growth."

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