STOCKS
Equities posted healthy gains last week with small caps showing the greatest strength. Investors mainly sat on the sidelines on Monday waiting on the FOMC statement Wednesday and a plethora of economic data coming during the week. Equities got a boost on Tuesday with a rise in consumer confidence data and due to strong earnings, although higher oil prices were partially offsetting. Stocks rose Wednesday in celebration of the FOMC meeting statement that inflation was improving and also due to the healthy GDP report combined with moderate deflator numbers and moderate employment compensation costs in a separate report. Thursday's low number for the core PCE deflator in the personal income report pushed equities up, including the Dow to a record close. Finally, Friday's modest employment report was welcomed as fitting the Fed's soft landing plan. The Dow, however, retreated from Thursday's record close - basically just noise after being up the rest of the week. Other indexes posted modest gains on Friday, seeing the combination of modest January employment numbers with upward revisions to November and December as a plus.

Last week, equities finally put together the first strong week of 2007. For the week, the Dow, was up 1.3 percent; the S&P500, up 1.8 percent; the Nasdaq, up 1.7 percent; and the Russell 2000, up a sharp 2.7 percent.

Gains during the first three days of last week (the last three days of January) helped January end up being a respectable month despite some mid-month losses. The technical sector and small caps led the way.

Year-to-date (inclusive of two days in February), the Dow is up 1.3 percent; the S&P500, up 1.8 percent; the Nasdaq, up 1.7 percent; and the Russell 2000 is up 2.7 percent.

BONDS
The bond market just cannot quite decide on where the economy is headed and then stick with it - but that is not news. Before last week, the bond market believed that economy was starting to look like it was getting too strong and rates were rising. This past week, inflation numbers were generally favorable and the economic data ended the week on the more moderate note. Blow by blow, bond traders largely sat on the sidelines Monday and Tuesday, waiting on the FOMC statement on Wednesday and waiting to see what the economic data later in the week would look like. On Wednesday, favorable GDP price index numbers, slower growth in unit labor costs, and kind comments from the Fed acknowledging an improvement in inflation all helped to push rates down - especially on the far end. There was a little firming on Thursday due to a drop in jobless claims and a rise in the ISM price index offsetting a slightly negative ISM composite index. Friday's employment report that showed modest payroll gains for January helped intermediate bond rates dip a notch.

Net for the week the Treasury yield curve is down notably except for the 3-month T-bill which was unchanged. Yields are down as follows: 2-year Treasury note, down 4 basis points; 3-year, down 4 basis points; 5-year, down 5 basis points; the 10-year bond, down 6 basis points; and the 30-year bond, down 5 basis points.

Last week partially reversed a recent uptrend in rates. Rates have been trending upward over the last month or somewhat longer. Short-term rates are up net about 25 to 35 basis points since the end of November. Meanwhile, the long bond rate is up net about 35 basis points but since mid-December.

Markets at a Glance

The Economy
Last week got a heavy dose of economic data. We found out that the fourth quarter was stronger than believed by many, that the consumer was robust in December, but that inflation had eased somewhat. To end the week, the January jobs report indicated that February might be somewhat sluggish - but after a recent spate of possibly too strong economic numbers, it was welcome news.

Employment report is "just right"
The just released January employment situation report sets the tone for expectations for upcoming economic data. And after the markets were beginning to fear that the economy is too strong and that there might be a chance the Fed will raise rates before cutting rates, news that the economy is moderating was very welcome. Nonfarm payroll employment posted a 111,000 gain in January, following a revised 206,000 increase in December and 196,000 rise in November. December's figure was revised up 39,000 from the initial estimate of a 167,000 increase and November was revised up 42,000 from the previous estimate of a 154,000 boost. Nonfarm payroll employment is up 1.6 percent year-on-year for January, compared to 1.7 percent in December.

Also suggesting slight moderation in the labor market was an uptick in the civilian unemployment rate to 4.6 percent from 4.5 percent in December.

Personal income was strong in December but may be outdated with the January jobs report
Personal income growth was quite healthy in December with a 0.5 percent increase in December - the same as in November. The wages and salaries component was even stronger with a 0.6 percent boost in the latest month. The wages and salaries component is the largest within personal income and is the component that has the biggest impact on consumer spending. Personal income is up 5.9 percent on a year-on-year basis in December, unchanged from November.

However, looking ahead, last Friday's jobs report indicated that employment growth slowed, the workweek edged down a notch, and wage growth slowed - indicating that personal income will not be as strong in January. But given recently robust growth, a little moderation will be welcomed.

The latest personal income report still showed the consumer keeping the economy going. Personal consumption expenditures rose 0.7 percent in December, following a 0.5 percent increase in November. Gains were widespread by components. Personal consumption is up 6.0 percent year-on-year in December, compared to 5.7 percent in November.

ISM and Chicago NAPM manufacturing weaken
While there is talk of the housing sector being near bottom and even resuming growth in the near future, there are signs that manufacturing may be a little soft. The Institute For Supply Management's manufacturing index dipped in January to a sub-50 contractionary reading of 49.3 from 51.4 in December. The reading is the second sub-50 reading in the last three months.

Meanwhile, the Chicago NAPM index also weakened. The Chicago purchasing managers' index fell to 48.8 in January from 51.6 in December. Both the ISM and Chicago NAPM have been reporting soft new orders.

Rear view mirror - GDP shows the economy to be quite healthy in the fourth quarter
Fourth quarter real GDP jumped to an annualized 3.5 percent from the 2.0 percent pace in the third quarter. The acceleration in growth was primarily due to acceleration in growth in nondurables personal consumption, government purchases, and in exports as well as a drop in imports. Partly offsetting these factors were a slowing in inventory growth and a small decline in business fixed investment.

Year-on-year, real GDP is up 3.4 percent in the fourth quarter, compared to 3.0 percent in the third quarter.

The GDP report frequently is old news - even with the advance report. What did we learn from the dated fourth quarter data that gives insight into where the economy is headed' First, overall strength for the quarter was led by personal consumption and net exports. Overall PCEs advanced 4.4 percent, following a 2.8 percent rise in the third quarter. Will this continue' If the January employment report is accurate in suggesting a slowing in personal income, then we may get some moderation in consumer spending in coming months and that would slow GDP growth.

The key source of fourth quarter growth was net exports which narrowed sharply in the fourth quarter to a deficit of $581.4 billion from a shortfall of $628.8 billion in the third quarter. Real exports jumped a sharp 10.0 percent, following a 6.8 percent boost in the third quarter. Real imports actually fell an annualized 3.2 percent, following a 5.6 percent increase in the third quarter. Are these trends likely to continue' Neither the export growth nor the import declines are likely to continue as during the fourth quarter. Foreign central banks have been tightening and that will slow their countries' economic growth and demand for U.S. exports. The fourth quarter dip in imports appears to at least partly an adjustment in inventories and will not continue. Inventory investment slowed to a gain of $35.3 billion from 55.4 billion in the third quarter. The fourth quarter was good for bringing inventories back in line.

On the plus side, residential investment fell at about the same pace as in the third quarter. Yes, it was down but not accelerating and that means it was not pulling the economic growth down. In fact, in coming quarters, if housing investment falls at a slower pace, it is actually contributing to economic growth. Business fixed investment was a little sluggish but largely reflected coming off a strong third quarter and resuming a moderate growth path.

Overall, component analysis of the strong fourth quarter mostly suggests moderation in coming quarters rather than acceleration.

On a final note on GDP, how did the economy fare in 2006' Did the economy meet or beat expectations' Most economists expected 2006 to be slower than 2005 due to the cumulative effects of the Fed's 17 consecutive interest rate hikes ending in June 2006 and due to the housing recession. In reality, real GDP in 2006 outpaced 2005 by either measure - annual average or fourth-quarter-over-fourth-quarter. On an annual average basis, real GDP rose 3.4 percent in 2006, compared to 3.1 percent in 2005. On a fourth-quarter-over-fourth-quarter basis, real GDP posted a 3.4 percent increase last year - slightly above the 3.1 percent pace in 2005. The U.S. economy has proven to be quite resilient and traditional "leading" sectors - such as housing and autos - have not been a good bellwether for recession as might have been the case in the past.

The Fed and last week's inflation picture
Despite all of the generally favorable economic data last week, the big news was the acknowledgement from the Fed's FOMC that inflation is improving. In case you missed it, the key sentence was, "Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time." This one sentence relieved anxiety by many in the markets that the Fed might be about to increase rates. This is what helped to boost bond prices and equities last week. Nonetheless, the Fed retained an anti-inflation bias, indicating the further rates increases are possible but dependent on incoming data. The Fed still projects economic growth will moderate in coming quarters.

So, how do the data stack up to the Fed having nice things to say about inflation' Last week's indicators actually had a lot of new information. Instead of scattering that information in each of the reports' commentary, it is summarized below.

In the personal income report, the overall PCE price deflator was boosted due to oil prices but was subdued at the core level. The overall PCE price index jumped to a 0.4 percent gain, following no change in November. Core inflation remained modest with a 0.1 percent rise in December, following no change in November.

On a year-on-year basis, the overall PCE deflator is up 2.3 percent in December, compared to up 1.9 percent in November. On a year-on-year basis, the core deflator was unchanged at up 2.2 percent. But what about more current trends - year-on-year data move slowly'

On a 3-month-ago annualized percent change basis, recently weak core data for both the PCE price index and the CPI have fallen below the Fed's implicit upper limit on acceptable inflation - the upper limit being 2 percent and the lower limit being 1 percent. For December, these percent changes for the core PCE deflator and the core CPI were 1.4 percent and 1.7 percent, respectively. However, the Fed knows that such data are still a little volatile as seen in the above chart. The true inflation trend probably lies somewhere between the year-on-year measure and the 3-month-ago annualized numbers.

From the GDP report, the overall GDP price index slowed to 1.5 percent annualized from 1.9 percent in the third quarter. The latest deceleration partly reflects lower oil prices. The consensus had expected the overall GDP deflator to post a 1.5 percent increase in the fourth quarter. The core deflator for PCEs - the preferred inflation measure of the Fed - nudged down to 2.1 percent from 2.2 percent annualized growth in the third quarter.

Year-on-year, the GDP price index fell to up 1.9 percent year from up 2.8 percent in the third quarter. On the same basis, the core PCE deflator growth rate eased to up 2.3 percent in the fourth quarter from up 2.4 percent in the third quarter.

The primary area of concern for the Fed on the inflation front has been labor costs. Even labor cost indicators have started to improve. From the employment situation report, average hourly earnings decelerated to a 0.2 percent increase in January, following a 0.4 percent rise in December. Average hourly earnings are up 4.0 percent on a year-on-year basis in January. Despite the January uptick in unemployment, the unemployment rate remains quite low at 4.6 percent and will keep the Fed's attention.

The employment cost index decelerated to a non-annualized 0.8 percent in the fourth quarter from a 1.0 percent rise in the third quarter. Year-on-year, the ECI was up 3.3 percent in both the fourth and third quarters, up from a 3.0 percent rate in the second quarter and a 2.8 percent rise in the first quarter. Last week, the markets focused on the more marginal quarterly change than on the slower moving year-on-year rate.

And the final inflation data from last week are the more volatile numbers from manufacturing surveys - from Chicago NAPM and from ISM. The two surveys showed divergent price movement in the latest month but remain generally subdued. From the Chicago NAPM report last Wednesday, prices paid showed little pressure, easing slightly to 54.9 in January from 56.9 in December. The next day, the ISM prices paid index came in higher than expected, rising to 53.0 in January from 47.5 the prior month. Meeting or beating expectations is key, but the markets really made too much of the ISP price index figure. A 53.0 reading really is modest.

The bottom line
The economy appears to be on the proverbial soft landing and inflation is slowly coming down. There are even signs that labor cost inflation is easing. Still, the labor market is the Fed's primary area of concern and the Fed will not be too quick to assume that the economy has moderated sufficiently.

Looking Ahead: Week of February 5 through February 9
Looking ahead, we get a quiet week after so many numbers to digest last week. Company and industry data are likely to dominate next week along with Fed speak. Several FOMC members are discussing the economy, including Fed Chairman Ben Bernanke on Tuesday - with San Francisco Fed President Janet Yellen and Chicago Federal Reserve Bank President Michael Moskow also chiming in that day. Philadelphia Federal Reserve Bank President Charles Plosser speaks Wednesday morning while St. Louis Federal Reserve Bank President William Poole gives his economic perspective on Friday.

Monday
The business activity index from the ISM non-manufacturing survey remained healthy in December but eased slightly to 57.1 from 58.9 in November. But orders data in that report suggests a slowing in business activity growth. New orders dipped 2.7 percentage points to a still respectable 54.4 while backlog orders plunged 6.5 points to 48.0.

Business activity index Consensus Forecast for January 07: 57.0
Range: 53.5 to 58.0

Wednesday
Nonfarm productivity growth for the third quarter came in at an anemic 0.2 percent annualized, following 1.2 percent in the second quarter and 4.3 percent in the first quarter. Productivity needs to improve to keep inflation pressures down. Unit labor costs rose an annualized 2.3 percent, following a 2.4 percent decline in the second quarter. With last year's annual revisions downward, unit labor costs have been moderate despite a relatively tight labor market.

Nonfarm Productivity Consensus Forecast for initial Q4 06: 2.2 percent
Range: 1.0 to 2.5 percent

Unit Labor Costs Consensus Forecast for initial Q4 06: 2.0 percent rate
Range: 1.4 to 4.7 percent rate

Thursday
Initial jobless claims fell 20,000 in the week ended January 27 to 307,000 pushing the four-week average down 4,500 to 304,750 and its best level in a year. There were no special factors for the data.

Jobless Claims Consensus Forecast for 2/3/07: 312,000
Range: 310,000 to 325,000