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Last week saw both declining economic indicators and rising inflation. But subprime losses and Fedspeak indicated that the bigger problem of the two is the risk of recession. Fed Chairman Ben Bernanke acknowledged in congressional testimony that the economy was weaker than expected during the middle of last year and that the Fed is prepared to act as needed. Markets chose to focus on the gloomier parts of Bernanke’s comments rather than on his assurances.
 Equities ended the week down as recession worries outweighed good news for bond insurers. Stocks actually rallied notably the first two days of the week with Monday’s jump largely due to announcements of favorable ratings for bond insurers Ambac and MBIA. Genetech led the tech sector on Monday after the FDA gave approval for use of Avastin in the U.S. On Tuesday, equities were lifted by favorable company news despite an unfavorable PPI report. IBM announced both an upbeat outlook and a $15 billion buyback in company shares. Fedspeak from Fed Vice-Chairman Donald Kohn also boosted stocks as he indicated the Fed would do what is needed to keep the economy growing. Stocks were little changed on Wednesday as investors took the first day of Fed Chairman Bernanke’s semiannual Congressional testimony in stride. Bernanke’s signaling of further rate cuts offset a weak durable goods report.
But it was a different story on Thursday for Bernanke’s second day of congressional testimony. The Fed chief indicated that a number of small banks were likely to fail due to real estate losses and this raised recession fears, pushing down equities. Additionally, initial unemployment claims rose notably. Stocks fell sharply on Friday on heightening recession worries. Weak economic data included a drop in the Chicago purchasing managers’ index and flat real consumer spending in the personal income report. The announcement of a steep $5.3 billion quarterly loss by AIG after close on Thursday also weighed on stocks as did Dell’s drop in profits.
Last week, major indexes were down significantly as follows: the Dow, down 0.9 percent; the S&P 500, down 1.7 percent; the Nasdaq, down 1.4 percent; and the Russell 2000, down 1.3 percent.
 On a monthly basis, most equity indexes have fallen four months in a row. For February, declines were led by techs and small caps.
Since year-end, major indexes are down as follows: the Dow, down 7.5 percent; the S&P 500, down 9.4 percent; the Nasdaq, down 14.4 percent; and the Russell 2000, down 10.4 percent.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
 Treasury yields last week fell on both weak economic indicators and on flight to quality. At the start of the week, however, rates nudged up notably as MBIA and Ambac received favorable news on their credit ratings. This news boosted stocks and pulled funds out of Treasuries. The next big move in rates was Thursday as yields dropped significantly on comments by Fed Chairman Bernanke that the Fed will be cutting interest rates. His comments about likely failure of some small banks also boosted flight to safety due to recession concerns. Rates fell further on Friday on a drop in the Chicago purchasing managers’ index and on weak consumer sentiment data.
 Treasury yields were down last week as follows: 3-month T-bill, down 36 basis points, the 2-year note; down 41 basis points; the 5-year note, down 37 basis points; the 10-year bond, down 29 basis points. and the 30-year bond, down 16 basis points.
A weak economy and flight to quality have pushed bond yields down sharply.
 Oil prices last week not only breeched the century mark again but set a new record close and ended the week well over $100 per barrel. Spot prices for West Texas Intermediate rose during the first two days of the week with Tuesday particularly strong due to supply concerns and the view that worldwide demand is still strong despite a sluggish U.S. economy. Prices eased somewhat on Wednesday on recession concerns and on higher than expected inventories. But Thursday saw a $2.57 per barrel surge to a new record high of $102.21 per barrel. Expectations of lower interest rates and a drop in the dollar fueled Thursday’s jump in prices. At week end, the exit of Turkish troops from Kurdish northern Iraq led to a slight easing of prices.
The spot price for West Texas Intermediate rose $2.88 per barrel net for the week to settle at $101.84 per barrel, 37 cents below the record high of $102.21 set the day before.
This past week economic data generally came in weak and further pointed to the likelihood of a mild recession. In particular, durables orders fell sharply, housing sales continued to plummet, and consumer spending on an inflation adjusted basis is flat. Meanwhile, Fed Chairman Ben Bernanke indicated the Fed’s willingness to continue to cut interest rates as needed – even in the face of this past week’s jump in inflation numbers.
 For the first revisions to fourth quarter GDP, real GDP was unrevised at an annualized 0.6 percent and followed a robust 4.9 annualized increase in the third quarter. The deceleration in growth was primarily due to a downturn in inventory investment and decelerations in exports, in PCE, and in federal government spending that were partly offset by a downturn in imports.
 The latest price numbers still show inflation picking up significantly last quarter at the economy-wide and consumer levels. The fourth quarter GDP price index was revised up slightly to 2.7 from the initial estimate of 2.6 percent. The headline PCE price index growth rate came in at a hot 4.1 percent in the final quarter, jumping from up 1.8 percent in the third quarter. However, the core PCE price index growth rate firmed at up 1.7 percent in the final quarter, compared to up 2.0 percent in the third quarter.
In summary, the latest GDP numbers show a flat economy while inflation is still too high.
 Personal income in January slowed to a 0.3 percent gain, following a 0.5 percent increase the month before. Within personal income, the wages and salaries component rose 0.5 percent after a 0.4 percent boost in December. On the spending side, personal consumption advanced 0.4 percent, after a 0.3 percent gain in December. The consensus projected a 0.2 percent rise in personal spending in the latest month.
 But the big story is that inflation worsened in January as the overall PCE price index increased 0.4 percent, following a 0.3 percent boost in December. Even the core PCE price index firmed with a 0.3 percent gain in January after a 0.2 percent rise the month before. Year-on-year headline inflation moved further away from the Fed’s implicit target zone, coming in at 3.7 percent, compared to 3.6 percent in December. Core inflation, year-on-year, held steady at 2.2 percent in January.
While many market analysts focused on the apparently moderate nominal spending numbers, consumer spending is actually very weak after taking into account inflation. That is, inflation is eating into the consumer’s buying power. After inflation is discounted, consumer spending was flat in January and in December. This will pull GDP growth down in the first quarter unless there are notable offsets elsewhere.
Friday’s report shows the consumer sector healthier than expected on the income side but also points to the growing problem of inflation. Real personal consumption numbers coming in flat in both December and January suggest that there is an increasing chance that first quarter growth will be negative. Personal spending makes up about two-thirds of GDP.
 Existing home sales slipped 0.4 percent in January for a 23.4 percent year-on-year decline that is the worst on record.
Supply is the really bad news in the report, which swelled to 10.3 months from 9.7 months in December. The median price fell 2.9 percent in the month to $201,100 for a year-on-year decline of 4.6 percent. Prices have begun to slip the last few months, but sellers continue to keep their homes on the market.
The bottom line is that bottom is not yet in sight for housing. Demand is going to have to pick up and reduce inventories before new construction can rebound.
 New home sales continued to plunge in January, falling 2.8 percent to a 588,000 annual rate for a year-on-year decline of 34 percent. For perspective, the 588,000 rate is among the very the lowest since the 1991 recession.
Prices now appear to be almost in freefall, dropping 4.3 percent in January alone following a 9.3 percent plunge in December. Sellers appear to be growing desperate to unload homes that have languished on the market. The year-on-year decline is at 15.1 percent -- a record for the series which goes back to the early 1960s. Supply is swollen, at 9.9 months and is the highest of this housing slump and the worst since the recessions in 1991 and the early 1980s.
 Even as the real economy is slowing or declining, inflation has picked up. Overall producer price inflation surged in January while the core rate also firmed. The overall PPI jumped a monthly 1.0 percent in January, following a 0.3 percent dip in December. The core rate inflation increased to a 0.4 percent, following a 0.2 percent rise in December. But in the near term, with the economy still on the soft side, higher producer prices may bode ill for retailer profits as much as for nudging up inflation. Businesses may only be able to pass along part of the increased costs. This trend is likely to undermine profit and equity values.
 The year-on-year rate for the overall PPI soared to up 7.7 percent in January (seasonally adjusted) from up 6.5 percent in December. This is the highest rate since 7.9 percent seen in September 1981. The year-on-year core rate increased to up 2.4 percent in January from up 2.1 percent in December. This is the highest rate for the core since 2.5 percent seen in September 2005. The strong inflation numbers will be making it difficult for the Fed to keep interest rates down for long.
 There are further signs that manufacturing is headed into recession. Durable goods orders dropped sharply in January, further pointing to a decline in the manufacturing sector and possibly the economy overall. Durable goods orders retreated 5.3 percent in January, following a 4.4 percent surge in December. Even excluding the volatile transportation component, new orders still came in weak, falling 1.6 percent in January, following a 2.0 percent boost in December. While a large portion of January's weakness was in aircraft orders, declines were fairly widespread. Certainly, the new orders series is one of the most volatile economic indicators and indeed January is coming off a strong December. The trend, however, is headed down but not as much as indicated by January alone.
 There are signs of weakening in the economy beyond just manufacturing and housing. The Chicago NAPM report dropped 44.5 in February from 51.5 in January and a very strong 56.4 in December. The break even point is 50 with sub-50 readings indicating a contraction in activity. New orders remained in negative territory at a 48.8 level that may be 4 points higher than January but, because it's a sub 50 reading, indicates a month-to-month contraction from January. Higher costs remain a concern for businesses in the Chicago area. Prices paid remains severely elevated at 79.4 in February.
Last week Federal Reserve Chairman Ben Bernanke gave his semiannual report to Congress on monetary policy. In his prepared remarks, the Fed Chair focused more on downside risks to economic growth but acknowledged that inflation could rise due to a weaker dollar and higher oil prices and other commodity prices. His repeated references to downside risks, nonetheless, left a clear impression that the Fed is still in easing mode. "The risks to this outlook remain to the downside. The risks include the possibilities that the housing market or labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further."
But during Q&A, Bernanke said he does not anticipate the economy will be mired in stagflation, saying conditions are "nowhere near" those of the 1970s. Bernanke expects inflation to come down and real growth to improve.
The Fed chair did give several comments that increased market worries about recession. The Fed chief does see the current economy as being different from those in 2001. Bernanke indicated that current issues are more difficult than those after the tech bubble in 2001, suggesting not only that the Fed will be cutting rates but also that economic sluggishness may last more than many have anticipated.
Also catching market attention was Bernanke’s bluntness about the housing market's impact on some regional or smaller banks. He stated there "probably will be some bank failures" due to real estate losses. But "among the largest banks, capital ratios remain strong."
 The bottom line is that Bernanke has signaled that the risk of recession and continuing credit market problems are the more important issues for the Fed and that inflation worries have been pushed to the back burner – at least for now.
Meanwhile, the fed futures market has now priced in a 75 basis point cut in the fed funds target rate at the March 18 FOMC meeting. And future traders are even anticipating a 1.75 percent target by July.
Economic data continue to point to a weak economy. The Fed currently fears “downside risks” to the economy more than inflation and in fact is expecting a weak economy and a slowing in energy inflation to bring down inflation in coming quarters. The Fed appears poised for further rate cuts on March 18 and possibly thereafter. For the markets, the question now is how fast will the Fed cut' More are betting on faster cuts, including a possible 75 basis point drop on March 18.
This coming week two market moving indicators bracket the week -- starting with the ISM manufacturing index on Monday and ending with the employment situation report on Friday. Second tier indicators give us updates on construction, manufacturing, and consumer spending, among others. But the highlight, of course, will be the February jobs report at week end which will give us a better idea on whether or not the economy is teetering into recession.
Motor vehicle sales were very weak in January, at an 11.7 million annual unit North American-made rate. The rate is the lowest since mid-year and otherwise the lowest since 1993. Manufacturers said they were disappointed in the results, raising the likelihood of an incentive push in February.
Motor vehicle sales Consensus Forecast for February 08: 11.95 million-unit rate
Range: 11.30 to 12.20 million-unit rate
The Institute for Supply Management’s manufacturing index in January edged back over the 50 level to 50.7, up 2.3 points from December. Production jumped nearly 7 points to 55.2 in January, a good start to the manufacturing year. But indicators for future production are less optimistic with new orders at 49.5, a sub-50 reading, and with backlog orders in the negative also at a 44.0 level.
ISM manufacturing index Consensus Forecast for February 08: 48.1
Range: 46.0 to 50.5
Construction spending in December fell sharply, declining 1.1 percent in December, following 0.4 percent decline in November. December's drop in construction spending was led by a 2.8 percent drop in private residential outlays. Public outlays also declined, down 1.5 percent. On the positive side, private nonresidential rose 1.3 percent in December, following a 1.8 percent gain the prior month. On a year-on-year basis, overall construction outlays were down 2.3 percent in December.
Construction spending Consensus Forecast for January 08: -0.7 percent
Range: -1.5 to -0.4 percent
Nonfarm productivity slowed in the fourth quarter, reflecting a slowing in the economy. In the initial estimate, fourth quarter productivity decelerated to an annualized 1.8 percent increase, following a 6.0 percent surge in the third quarter. Unit labor costs rebounded 2.1 percent annualized in the fourth quarter, following a 1.9 percent decline in the third quarter. Given that fourth quarter GDP was unrevised at a 0.6 percent growth rate, there are not likely to be any dramatic revisions to fourth quarter productivity or unit labor costs. However, some revisions may occur due to somewhat different methodologies in measuring output and hours worked were revised slightly.
Nonfarm Productivity Consensus Forecast for revised Q4 08: +1.8 percent
Range: +1.0 to +2.0 percent
Unit Labor Costs Consensus Forecast for revised Q4 08: +2.1 percent rate
Range: +1.4 to +4.2 percent rate
Factory orders jumped 2.3 percent in December, reflecting a 5.0 percent surge for durable goods but being restrained by a 0.4 percent decline in nondurable orders. More recently, durables dropped 5.3 percent in January due to a fall in aircraft orders. While nondurables orders once again may be affected by a swing in oil prices, this time upward, this will not be enough to offset the drop in durables in January.
Factory orders Consensus Forecast for January 08: -2.5 percent
Range: -3.0 to +2.3 percent
The business activity index from the ISM non-manufacturing survey plunged to 41.9 in January from 54.4 in December. This is the most extreme move on record and the lowest reading since the 2001 recession. New orders also dropped to 43.5 from 53.9 -- again the lowest reading since the recession. The non-manufacturing index suggests that it is not just housing and manufacturing that may be heading into recession.
Business activity index Consensus Forecast for February 08: 47.5
Range: 43.0 to 52.2
The Beige Book being prepared for the March 18 FOMC meeting is released this afternoon. Recent Fedspeak has focused on downside risks to the economy and markets increasingly have been pricing in a 75 basis point cut in the fed funds target rate. The Beige Book may give some hints on whether such a super-sized rate cut is likely or merely a 50 basis point cut.
Initial jobless claims rose 19,000 in the week ending February 23 to a very elevated level of 373,000. The February 23 week was a shortened holiday week, which places special importance on the four-week average which actually slipped slightly but to a still well elevated 360,500. Continuing claims also signaled weak conditions, jumping 21,000 in the February 16 week to 2.807 million. The labor market clearly appears to be softening, but not dramatically.
Jobless Claims Consensus Forecast for 3/1/08: 360,000
Range: 355,000 to 370,000
Nonfarm payroll employment in January surprisingly fell for the first time in over four years. Nonfarm payroll employment in January fell 17,000, following revised increases of 82,000 in December and 60,000 in November. On the inflation front, average hourly earnings posted a 0.2 percent gain in January, following a 0.4 percent rise the prior month. The civilian unemployment rate edged back down to 4.9 percent from 5.0 percent in December. More recently, initial unemployment claims suggest that employment is continuing to soften but not dramatically. Another weak payroll number is likely for February and there is a good chance the unemployment rate ticks back up.
Nonfarm payrolls Consensus Forecast for February 08: +25,000
Range: -50,000 to +50,000
Unemployment rate Consensus Forecast for February 08: 5.0 percent
Range: 4.9 to 5.1 percent
Average workweek Consensus Forecast for February 08: 33.7 hours
Range: 33.6 to 33.8 hours
Average hourly earnings Consensus Forecast for February 08: +0.2 percent
Range: +0.2 to +0.3 percent
Consumer credit rose a moderate $4.5 billion in December, well down from a $17.1 billion surge in November which reflected that month's very strong retail sales. Credit increases in December were split about evenly between revolving and non-revolving. Looking ahead for January, vehicle sales were especially soft, pointing to slowing in non-revolving credit. Chain-store sales were better than vehicle sales and may feed January gains in the non-revolving category (credit cards). While an increase in consumer credit can point to increased consumer confidence, it also can suggest that consumers are being forced to rely on credit cards to meet monthly bills. This is an issue the Fed will be debating – whether consumer credit growth is healthy or whether the growth reflects sick consumer balance sheets.
Consumer credit Consensus Forecast for January 08: +$7.3 billion
Range: +$1.5 billion to +$12.8 billion
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