BONDS
The chart below, depicting the Friday levels of the 2-year and 10-year note yields, does not appear to have changed at all over the past couple of months. The spread between the 2-year and 10-year note remains quite tiny. It was 28 basis points at Friday's close.

Bond investors have gone back and forth on the question of a Fed pause. Will the Fed not raise the fed funds rate target by 25 basis points at Tuesday's FOMC meeting because of a potential economic slowdown stemming from the aftermath of Hurricane Katrina' Or will the Fed stay the course and continue to focus on the inflationary pressures coming from energy prices - and the aftermath of Katrina' Economists were divided on the issue as well, but it now appears that the majority of forecasters are going with continued rate hikes at this time.

There is no question that the post-FOMC meeting statement will be more important than ever. And markets will be surprised on Tuesday - no matter what the Fed ultimately does.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

The Economy

OUTSIDE ENERGY, INFLATION IS TAME IN AUGUST
The producer price index increased 0.6 percent in August after posting a 1 percent hike in July. The consumer price index recorded 0.5 percent gains in both July and August. To no one's surprise, the primary culprit is energy. August energy prices increased 3.7 percent in the PPI while they jumped 5 percent in the CPI. Note the PPI generally prices goods at mid-month, while CPI prices are gathered throughout the month including the last day of the month. This means that gas price hikes that took place after Katrina were starting to be factored in the CPI. But Labor Department officials noted that sharp energy hikes have yet to be felt in the CPI. Expect much larger gains in September.

Excluding food and energy, both the PPI and the CPI were tame during the month. The core PPI was unchanged, held down by declines in auto prices as well as computer prices. The core CPI increased 0.1 percent for the fourth straight month. Although apparel prices jumped 1 percent (after declining in the two previous months) prices of other goods were surprisingly tame. For instance medical care costs were unchanged during the month, the best showing since late 1975! Total housing costs increased 0.2 percent, held down by lodging away from home which posted a 1.6 percent drop for the month. Education and communication costs dipped 0.1 percent as educational books and supply costs fell 0.1 percent for the month. This confluence of friendly positive factors is not necessarily going to repeat again in coming months. But at least through August, core prices were not accelerating.

Federal Reserve officials do not base their policy on history, though. The Fed will be concerned with price pressures stemming from the highly stimulative fiscal policy plans and the rebuilding that will result from the Katrina devastation. So even if the Fed can feel comfortable with the August inflation figures, they must look ahead.

RETAIL SALES PLUNGE, BUT HEADLINE NUMBER IS MISLEADING
Retail sales dropped 2.1 percent in August, more than reversing July's 1.8 percent hike. The decline was due entirely to the auto sector where sales at motor vehicle & parts dealers plunged 12 percent in August! This just about reverses the cumulative increase of 11.1 percent that took place in June and July. Automakers tend to create a lot of volatility in sales when they play the incentive game (on/off). The August drop in motor vehicle sales, though, was not all about incentive removal. It appears that consumers decided to take a pass on light trucks despite the heavy incentives that were still being offered. Maybe consumers are finally realizing that high gas prices and big tanks don't help their financial balance statement.

Excluding the auto group, retail sales increased 1 percent in August, twice as fast as July's 0.5 percent gain. But before one gets too excited about the seemingly strong figure, keep in mind that half of that gain was due to gas station sales - where price spurts helped increase the nominal value of spending. Excluding autos and gas, retail sales increased 0.5 percent for the month, a solid increase, but this follows no growth in July. Indeed, take a look at the chart below and notice that the trend in spending on goods other than gasoline and autos has moderated significantly in the past few months relative to earlier in the year. A 6-month moving average of nonauto, nongas retail sales shows average monthly gains of 0.3 to 0.4 percent in July and August compared with average monthly gains of 0.5 to 0.7 percent in the previous nine months. Retail sales have indeed moderated as consumers have less discretionary funds to spend since gasoline prices have surged over the past year.

Due to the uncertainty surrounding how the economy will behave in the aftermath of Hurricane Katrina, economists and market players (and Fed policy makers) are closely monitoring consumer attitude surveys these days. And the University of Michigan's consumer sentiment index plunged in mid-September, falling 12.2 percentage points after posting a sharp 7.4 percentage point drop in August.

Over the long run, there is no question that consumer confidence is related to spending: when consumers are optimistic about economic conditions, they will spend more and when they are pessimistic about economic conditions, they will spend less. From one month to the next, it is less useful to use consumer attitudes as predictors of retail sales. However, there is also no question that consumer sentiment has certainly played a role in helping to determine whether or not we head toward recession - or at least some slowdown in spending. After the preliminary September consumer sentiment data were reported on Friday morning, everyone appeared to be pointing to the "CNN effect" where consumers become pessimistic after seeing horrific news. Indeed, consumer attitudes fell sharply (-9.7 points) in September 2001 too.

We agree that a certain portion of the September drop could be attributed to the CNN effect. However, consumers across the country were also facing significantly higher gasoline prices. In fact, gasoline prices were already rising in August - and that's why the consumer sentiment index had fallen in the previous month. The chart below depicts the path of the consumer sentiment index back to 1980 with the shaded bars representing recessions. Declines of the magnitude posted for this September are highly unusual. The last decline of 12.2 was seen in December 1980. We are not, by any stretch of the imagination, predicting a recession because of these figures. However, it is more likely that the large declines posted in August and September are not entirely due to the CNN effect and are in part due to rising gasoline prices which are making consumers feel poorer. Gas prices have fallen at the pump in the past week or so, but by a very small amount. Consumers are still not happy about $3/gallon gas. While consumers were very optimistic about economic conditions from 1995 - 2000 (during the period of irrational exuberance in the stock market) they were less optimistic from 1991 - 1995, but consumer spending was still growing during this period. The consumer sentiment index appears to be in the same range from 2001 - 2005 as we saw in the early 1990s. More relevant than September's confidence numbers will be October's confidence figures - will we see a reversal for the month' That will be more telling about whether consumers are truly optimistic or pessimistic about current conditions.

PRODUCTION GROWTH CURTAILED BY KATRINA
While most of the August data do not really show a negative impact from Katrina, industrial production growth was indeed curtailed by the hurricane. According to Federal Reserve estimates, growth was reduced by 0.3 percent points in August. Consequently, the index of industrial production inched up only 0.1 percent for the month. Manufacturing production increased 0.3 percent, but mining fell 0.6 percent and utilities dropped 0.5 percent. The chart below compares year-over-year changes in manufacturing production to year-over-year changes in production of motor vehicles & parts and high tech. The red line depicts manufacturing (against the left axis) and shows a downward trend that began over a year ago. The blue line (against the left axis) shows a lot of volatility in terms of vehicle production. Given that automakers stop and start incentives to sell cars, it isn't surprising that they would need to stop and start assembly lines too. High tech production (the teal line against the right axis) shows that production growth has been fairly steady - leading to year-over-year gains of roughly 20 percent over the past two years. The high tech sector can't get industrial production out of its doldrums, though, since it accounts for only 4.5 percent of production, whereas motor vehicle & parts production accounts for more than 7 percent of the index.

Most likely, the aftermath of Katrina will curtail production growth in September as well. The impact could be larger since a bigger portion of the month will be impacted.

The regional Fed surveys, which can sometimes be used as leading indicators for national surveys, showed moderation in manufacturing activity in September. The general conditions index from the Philadelphia Fed survey fell back to 2.2 in September from a level of 17.5 in August. While any level over zero still represents growth rather than contraction, this marks a significant moderation in the rate of growth. Even more noteworthy was the drop in the index level for the 6-month outlook -- from 33.4 in August to 7 in September. A special question on this survey focused on energy prices. For the most part, manufacturers are indeed finding that higher energy prices are dampening production and new orders.

The Empire State manufacturing survey wasn't as weak as the Philly Fed survey. The general business conditions index fell back to 17 in September from 23 in August. While the New York Fed did note that data were gathered between September 1 and 14, (post-Katrina), they did not appear to indicate whether any of the decline was directly due to Katrina.

JULY TRADE DEFICIT NARROWS
The international trade deficit narrowed in July to $57.9 billion after widening in June to $59.5 billion. While exports only increased 0.4 percent in July, imports fell 0.7 percent for the month. There was no single category of exports that posted strong gains; they were small, but widespread. Imports of crude oil increased, but imports of nonauto capital goods fell, as did imports of nonauto consumer goods. While exports have not exhibited a sharp growth acceleration over the past year, the year-over-year gain in imports has moderated significantly during the period. On the whole, most economists are still predicting the international trade deficit will widen in coming months. Katrina could impact August and September figures - New Orleans is the fourth busiest port in the U.S. However, other coastal cities may have taken up the slack in the short run.

The Bottom Line
Federal Reserve officials will have plenty to mull over when they meet on September 20. Some economists believe that the tame inflation figures for August will give Fed officials the cover they need to take a momentary pause in their rate hikes. Other economists believe that the tame inflation figures will only make their job harder. Keep in mind that the Fed looks at more than old inflation news to make decisions. They are also monitoring daily commodity figures - and can call contacts in their regions to see how prices (and the economy) are behaving. I have no doubt that they plan to look at more than published data in light of Katrina. And Fed officials will take into account the highly expansionary stimulus that will develop from all that fiscal spending.

Looking Ahead: Week of September 19 to September 23

Tuesday
Housing starts were unchanged in July at a 2.042 million-unit rate. Mortgage rates rose about 10 basis points in August from the July average. Anecdotal evidence has housing activity moderating somewhat. Some marginal Katrina impact might be evident in August; I would expect more in September.

Housing starts Consensus Forecast for Aug 05: 2.04 million-unit rate
Range: 1.975 to 2.150 million-unit rate

Market players and economists are divided on what the Fed should do - and will do at the September 20 FOMC meeting. Some believe that a momentary pause would be good for the economy; others believe that the Fed should remain vigilant in their fight against inflation - particularly since Congress and the administration has targeted specific funds for rebuilding efforts. The majority of economists are currently expecting the Fed to raise rates on Tuesday.

Federal funds rate target Consensus Forecast for Sept 20 05: 3.75 percent (+0.25 percent)
Range: 3.50 to 3.75 percent

Thursday
New jobless claims jumped 71,000 in the week ended September 10 to 398,000. According to Labor Department officials, 68,000 claims were Katrina-related in the most recent week. Thus far, they have measured roughly 84,000 Katrina-related claims. The Labor Department does admit that due to claims being filed in various places (not the home state), we are likely to see revisions in coming weeks.

Jobless Claims Consensus Forecast for 9/17/05: 450,000 (42,000)
Range: 400,000 to 500,000

Several components of the index of leading indicators were negative in August: consumer expectations, vendor performance and the yield spread. Jobless claims and the factory workweek were unchanged. Thus far, only stock prices rose for the month.

Leading indicators Consensus Forecast for Aug 05: -0.3 percent
Range: -0.4 to -0.1 percent

Looking Ahead: Week of September 26 to September 30

Monday
Existing home sales fell 2.6 percent in July to a 7.16 million-unit rate. Sales fell most in the Northeast and the West. Mortgage rates have risen a bit in tandem with the long end of the Treasury market, but rates are still low by historical standards.

Existing home sales Consensus Forecast for Aug 05: 7.11 million-unit rate
Range: 6.24 to 7.20 million-unit rate

Tuesday
The Conference Board's consumer confidence index increased 2 percentage points in August even though the University of Michigan's index declined that month. September confidence is likely to drop - at least if the IBD/TIPP confidence index is any guide. It dropped almost 10 points in September!

Consumer confidence Consensus Forecast for Sept 05: 98
Range: 90 to 101.5

New single-family home sales jumped 6.5 percent in July to a 1,410,000-unit rate. Sales surged in the West, posted healthy gains in the Northeast, but declined in the Midwest and the South. Low mortgage rates should continue to support a strong housing market.

New home sales Consensus Forecast for Aug 05: 1,363,000
Range: 1,330,000 to 1,428,000-unit rate

Wednesday
New orders for durable goods plunged 4.9 percent in July. Such a plunge would normally be attributed to a drop in aircraft orders, but in fact durable goods orders were down across the board in July (except for primary metals).

Durable goods orders Consensus Forecast for Aug 05: 1.0 percent
Range: -1.6 to +2 percent

Thursday
New jobless claims will be closely monitored for the next few months - first to see the direct impact of Katrina and later to see indirect effects. Will the stimulative government aid help boost employment across the country'

Jobless Claims Consensus Forecast for 9/24/05: 400,000
Range: 390,000 to 500,000

According to the preliminary estimate compiled by the Bureau of Economic Analysis, real GDP expanded at a 3.3 percent rate in the second quarter of 2005. Consumer spending moderated slightly from the previous quarter's pace, but business fixed investment grew at a faster rate. However, the rate of inventory accumulation declined sharply in the second quarter, depressing overall growth.

Real GDP Consensus Forecast for Q2 05: 3.3 percent annual rate
Range: 3.0 to 3.4 percent annual rate

GDP deflator Consensus Forecast for Q2 05: 2.4 percent annual rate
Range: 2.4 to 2.4 percent annual rate

Friday
Personal income increased 0.3 percent in July. The August gain could be smaller, though, since private nonfarm payrolls increased only 0.1 percent, hourly earnings rose 0.1 percent, and the average workweek was unchanged. Personal consumption expenditures grew 1 percent in July. Motor vehicle sales plunged in August and this should dampen total consumer spending for the month.

Personal income Consensus Forecast for Aug 05: 0.3 percent
Range: 0.0 to 0.5 percent

Personal consumption expenditures Consensus Forecast for Aug 05: -0.2 percent
Range: -1.6 to 0.0 percent

The NAPM-Chicago's business barometer plunged to 49.2 in August, its lowest level in over two years. This index, which measures both manufacturing and non-manufacturing activity in the Chicago region, is often considered a leading indicator for the ISM manufacturing index. The Empire State and Philadelphia surveys were generally lower in September than in August and this could suggest another weak reading for the NAPM-Chicago.

NAPM-Chicago Consensus Forecast for Sept 05: 51
Range: 42 to 53

At mid-month, the University of Michigan's consumer sentiment index dropped more than 12 percentage points to reach 76.9, its lowest level since 1992! There is no question that hurricane devastation impacted consumer confidence in early September, but will confidence improve in the second half of the month' After all, gasoline prices are still high.

Consumer sentiment Consensus Forecast for Sept 05: 78.6
Range: 76 to 82