A few days ago an unusual event took place: Paul Volcker, the mythical U.S. Federal Reserve Board chairman from the Reagan years, criticized the policy of the current Fed chairman, Ben Bernanke, in a speech to the Economic Club of New York.

Just so you grasp how extraordinary this was, you should first understand that normally a past Fed chairman scrupulously avoids saying anything at all about current Fed policy - for the simple reason that the current Fed chairman's words are one of his most important tools: They can sway markets.

This ability does not fade entirely when a Fed chairman leaves.

So when a past Fed chairman speaks, his words can clash with those of the present one and make that one's job difficult. Out of professional courtesy, past Fed chairmen therefore keep quiet; Mr. Volcker especially - the man who hiked interest rates to 20 per cent to kill inflation, at the cost of a deep recession. But last week Mr. Volcker spoke his mind bluntly. He said, in effect, that the current Fed is not doing its job.

This would have been unusual enough. But Mr. Volcker went further. Not only is the Fed not doing its job, he said, but it is doing the wrong job: It is defending the economy and the market, instead of defending the dollar. And just to stick the knife in, Mr. Volcker added that this bad job now will make the real job - defending the greenback - much harder later. It'll cause even greater economic suffering.

In plain words, Mr. Volcker implied that the current Fed is not only incompetent, but that its actions are dangerous.

There is no record of Mr. Bernanke's reaction, nor that of anyone else inside the Fed. But there was plenty of buzz in the market because what Mr. Volcker said amounted to a rousing call to raise interest rates. Yes, raise rates, and do it now.

Can you imagine what this would do to the market? I sure can, which brings me to the gap between physical economic reality as we witness it every day in our physical investigations, and the surreal market chatter we see and hear on TV. This gap has never been wider - but it will inevitably close as markets catch up to reality - as just forecast by former president Ronald Reagan's Fed chairman. Let me cite three items, then go back to Mr. Volcker.

First, commercial real estate. You surely have read about the residential real estate problems - subprime loans syndicated and resold, causing the implosion of several U.S. financial institutions. The writeoffs and damage here total close to a trillion dollars, said the IMF recently. That's about one-seventh of the U.S. gross domestic product, or more than three years of growth.

But what of commercial real estate? I heard recently from some savvy private real estate investors that although commercial real estate fell by 20 per cent, it should fall by a further 20 to 30 per cent before it provides a reasonable rate of return. So whatever economic damage was done to the economy by residential real estate speculation may eventually be equalled by commercial real estate. Say another 10th or seventh of GDP erased, or another two-three years of growth gone.

Second, there's also the war in Iraq. Some U.S. economists recently estimated it has cost about two trillion dollars to date - another two-sevenths of U.S. GDP. That's five more years of GDP growth gone.

And third, we haven't even begun to tally the private equity blowups that are surely coming.

Taken all together, the economic damage spells a very bad and long recession. How to fix it? No problem, say the actions of Mr. Bernanke's Fed. Let's print the missing money - and it doesn't matter if it causes inflation and tanks the dollar. Because that's not our job.

Up to now Mr. Volcker kept quiet, but no more. In his speech he just said, in effect, that the recession is not the Fed's problem. It's the government's. The Fed's job is to defend the currency and fight inflation - exactly the opposite of what this Fed is doing. The solution? Raise interest rates, Mr. Volcker practically said, no matter the consequences now, because if you don't, you'll have to raise them even more later, with even more awful consequences.

Will rates indeed rise? I have no doubt they must. Not now, perhaps, but at the end of this year or the beginning of 2009, with a new president in the White House. The stock market, which usually looks six to nine months ahead, already understands this and may soon react. In fact, when Mr. Volcker's words sink in, the markets are likely to sink as this bear market rally ends.

For surely you understand we are still in a bear market - and only in the beginning of it? Yes, we are experiencing a rally, and like most bear rallies, it is sharp and spiky. But when bear rallies end, they leave a lot of spiked bulls behind - and this rally should be no different. When it is over - in the next few weeks, methinks - the waterfall could continue, as the market begins to digest the inevitability of higher inflation and higher interest rates ahead.

Against all protocol, Mr. Volcker just went out on a limb and warned you of this. I urge you to heed his words.

Globe & Mail