STOCKS
Overall, equities had a good week. Initially on Monday, the markets were mostly flat, waiting for Fed Chairman Ben Bernanke's testimony before Congress on Wednesday and Thursday. Energy stocks, however, fell on news that OPEC did not plan another production cut in March. Techs also were weak. On Tuesday, waiting on the sidelines had to wait as talk of Alcoa being purchased by either BHP Rio Tinto boosted Alcoa's stock. Other blue chips went along for the ride. Wednesday and Thursday got boosts from dovish commentary by Fed Chairman Ben Bernanke as the Dow continued to set record closes. Friday, blue chips were weighed down by rumors that GM is considering buying Chrysler from Daimler-Chrysler. Many analysts see Chrysler's "legacy" labor and retirement costs as being too much baggage. Other stocks mainly moved sideways after three strong days prior. Soft housing starts took a little momentum out of earlier gains but not much. The Dow managed to squeak into positive territory right at close after sitting just below Thursday's close all day. Much of the softness earlier in the day had been nothing more complicated that some profit taking. The Dow ended the week with four consecutive record closes.

Last week, the Dow, was up 1.5 percent; the S&P500, up 1.2 percent; the Nasdaq, up 1.5 percent; and the Russell 2000, up 1.4 percent.

Year-to-date, the Dow is up 2.4 percent; the S&P500, up 2.6 percent; the Nasdaq, up 3.4 percent; and the Russell 2000 is up 3.9 percent.

BONDS
The bond market ended the week with rates down significantly, continuing a downtrend that began the prior week. Rates actually firmed marginally at the start of the week on Monday, largely out of nervousness over what Fed Chairman Bernanke might indicate about monetary policy during his report to Congress coming later in the week on Wednesday and Thursday. Traders sat on the sidelines on Tuesday, not reacting much to the widening in the trade gap. On Wednesday, retail sales were healthy after discounting special factors, giving the markets some initial concern. But this was vastly outweighed by Fed Chairman's moderate comments on the inflation outlook, and rates dipped. Thursday's weak industrial production numbers and soft Philly Fed index more than offset a jump in the Empire State manufacturing index. Icing on the cake for the bond markets was Bernanke's second day of Congressional testimony which reaffirmed his day earlier dovish comments. Bond prices got another lift on Friday from a dip in producer prices and a fall in housing starts.

Net for the week the Treasury yield curve is down significantly except for the 3-month bill. Yields are down as follows: 2-year Treasury note, down 7 basis points; 3-year, down 9 basis points; 5-year, down 9 basis points; the 10-year bond, down 9 basis points; and the 30-year bond, down 7 basis points. The 3-month T-bill is up 2 basis points, tightly linked to a fed funds rate that is not expected to change for some time.

Rates have generally eased since late January, reflecting the view of the markets that economic growth is slowing, as confirmed by most economic data last week. The 3-month Treasury bill has been on a slight uptrend - barely - since the end of January. This has been due to an increasing belief that the Fed will not be cutting rates soon.

Markets at a Glance

The Economy
Last week showed further moderation in manufacturing, housing, and in prices at the producer and import levels. The consumer section remains the strongest sector, continuing to provide the backbone for economic growth in the U.S. And at mid-week, Fed Chairman Ben Bernanke speaking before Congress for the Fed's semiannual report to Congress actually calmed the markets over fears that the Fed might be thinking about raising short-term interest rates.

Consumer sector remains strong despite a weak headline retails sales figure
With manufacturing and housing soft, the consumer is the key to keeping economic growth moderately positive. And the consumer came through in January - once special factors are taken into account. Retail sales were unchanged in January, following a 1.2 percent surge in December. Weakness was primarily in motor vehicles and in gasoline sales. Outside of autos and gasoline, most components of retail sales actually posted moderately strong gains.

Year-on-year, overall retail sales in January were up 2.3 percent, down from up 5.7 percent in December. Excluding motor vehicles and gas station sales, year-on-year sales in January were up 4.3percent - down from up 6.3 percent in December.

Starts reverse on normal winter weather but permits slip little
The biggest risk to economic growth has been the housing sector. Markets have feared that this sector would continue to decline. This would eventually pull the consumer sector down due to decreased confidence and the lack of home equity gains to support spending. This is the one sector which the Fed has kept on its watch list. December's boost in housing starts gave the markets reason for hope but with the caveat that it was likely artificial due to unseasonably warm weather and seasonal factors jacking up the numbers. January's decline in starts confirmed that suspicion with starts falling 14.3 percent to a 1.408 million annual rate after a 5.0 percent boost in December.

However, the more interesting information may have come from permits - which the markets usually do not give much attention. Housing permits were more resilient than starts - they are probably not as impacted by monthly swings in weather. Overall permits declined 2.8 percent in January to a 1.568 million unit pace after rising 6.6 percent the month before. In the latest month, single-family permits fell 4.0 percent while multifamily permits edged up 0.4 percent. The greater stability in permits over the last two months may indicate a more accurate trend in housing - suggesting that this sector is leveling off.

Industrial production weakens in January
The manufacturing sector clearly has softened based on national data. Industrial production came in very weak in January with a 0.5 percent drop, following a 0.5 percent boost in December. Manufacturing output dropped 0.7 percent, following a 0.8 percent boost in December. For January, mining output decreased 1.2 percent while utilities output jumped 2.3 percent.

Most of the weakness in manufacturing in January was in durables but nondurables also was down. Durables output fell 1.3 percent in January, while nondurables declined 0.2 percent. Durables declines were led by motor vehicles & parts, machinery, and nonmetallic metals. Aircraft production was up. 1.1 percent.

Overall industrial output was 2.6 up percent year-on-year in January while that for manufacturing was up 1.8 percent. Overall capacity utilization in January slipped to 81.2 percent from 81.8 percent in December. For manufacturing, capacity utilization fell to 79.6 percent in January from 80.4 percent in December.

Empire State and Philly Fed manufacturing surveys give a mixed picture for February
Last week's numbers from regional manufacturing surveys gave a mixed picture for February. For regional reports, the Empire State report weighed in first last week on Thursday morning with a jump to 24.4 in February - much higher than January's level of 9.1. The survey's series for new orders and backlogs also improved sharply.

Later in the day on Thursday, the Philadelphia Fed's manufacturing index actually slipped to 0.6 from 8.3 in January. The index barely remained in positive territory - essentially pointing to flat production for the month. New orders weakened slightly - moving from just over break even to just below break even.

On the price front the New York Fed's prices paid index still showed month-to-month pressure at 26.9 but the level is well down from 35.1 in January. Prices received, which are output prices, fell back to 12.9 vs. 19.2. Prices paid in the Philadelphia report came in at 15.8 in February vs. 11.9 with prices received at 9.4 vs. 11.6 in January. Both reports are showing prices a little firmer than PPI data.

Trade gaps widens on rebound in oil prices; exports continue to grow
The U.S. trade gap widened to $61.2 billion in December from a revised $58.1 billion deficit in November. The increase in the trade deficit was primarily due to a jump in imports-primarily oil. In December, overall exports rose 0.6 percent, following a 1.1 percent jump in November. Overall imports increased 2.1 percent in December, following a 0.3 percent boost in November.

While we have learned to discount swings in oil prices as causing monthly volatility in the trade deficit, there are two long-term trends that bear remembering. Both imports and in exports have exhibited strong growth over the past two years. Import growth largely has reflected robust consumer demand in the U.S. This is likely to continue but to a lesser degree if job growth moderates. Also, exports have help bolster manufacturing in the U.S. Foreign demand for U.S. capital goods has been quite healthy. However, with monetary policy tightening overseas, we are likely to see a slowing in export growth and deceleration in manufacturing.

Producer prices stay on glide path down
The latest report on producer prices was favorable for further easing in overall inflation pressures - with lower oil prices helping significantly. Producer prices fell 0.6 percent in January, following a 0.9 percent increase in December. The decline was led by energy components. The core rate rose 0.2 percent in January - the same as in December. The core rate was kept moderate by declines in prices for passenger cars and for light trucks.

For the overall PPI, weakness primarily was in energy components - much as expected - and in motor vehicles. Energy fell 4.6 percent in January, following a 2.2 percent increase in December. January's decline was led by gasoline, down 13.0 percent; home heating oil, down 8.3 percent; and residential gas, down 1.9 percent. Light trucks - part of capital equipment - fell 1.4 percent while passenger cars slipped 0.1 percent.

The year-on-year rate for the overall PPI declined to up 0.2 percent from up 1.1 percent in December. The year-on-year core rate edged down to up 1.8 percent in January from up 2.0 percent in December.

Fed Chairman Ben Bernanke calms the markets with less hawkish Fed speak
Fed Chairman Ben Bernanke made his first semiannual monetary report to Congress with Democrats in control. Bernanke reiterated the usual Fed concern that maintaining inflation is the top priority. In addition to his prepared remarks, he delivered the FOMC's official semiannual report to Congress - including the Fed's forecasts for 2007 and 2008.

The most important outcome of Bernanke's remarks is that no change in Fed policy is pending. The implication is that the Fed is not shifting toward further interest rate increases but appears to be maintaining a wait and see posture on inflation trends. Bernanke's testimony was not as hawkish as some had feared it might be.

Some of the key comments were related to recently favorable inflation numbers.

"Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen, in large part as a result of declines in the price of crude oil. Readings on core inflation--that is, inflation excluding the prices of food and energy--have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated."

These comments were seen as less hawkish than recent comments by a few regional Fed bank presidents. But, Bernanke reiterated the position that it takes time to establish an inflation trend.

"As I noted earlier, there are some indications that inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated."

Essentially, a wait and see posture is still in effect for any change in monetary policy but there appears to be less risk for an increase in short-term interest rates

Chicago Fed President Moskow maintains his inflation risk bias
There is a group within the Fed that thinks there is still a notable risk that inflation will not come down enough without further Fed tightening. Speaking last week in Chicago, Chicago Fed President Michael Moskow reiterated his concern that inflation is running too high. Key comments were, "My assessment is that the risk of inflation remaining too high is greater than the risk of growth falling too low" and "Some additional firming of policy may yet be necessary to address this inflation risk." He expects moderate economic growth in 2007 based on a healthy consumer sector and to a lesser degree upon business investment. The bottom line is that most FOMC members see the soft landing on track but a notable minority still sees upside risks on inflation outweighing risks of too weak economic growth.

The Fed's Forecast for 2007 and 2008
Twice a year, the Fed presents to Congress a semiannual report which includes the Fed's composite forecast of those of each governor on the Board and each of the Fed regional bank presidents. The latest Fed forecast calls for real GDP growth of 2-1/2 to 3 percent in 2007 on a Q4/Q4 basis - down slightly from 3 to 3-1/4 percent forecast in July of 2006. Yet, the Fed's inflation forecast for 2007 is unchanged at 2 to 2-1/4 percent Q4/Q4 for the core PCE price index. This suggests that the Fed has incorporated a structural change in inflation fundamentals for such as demographic changes (slower growth in the labor force). Importantly, for 2008 (not forecast in July 2006), the Fed is project real GDP growth of 2-2/4 to 3 percent - which is slightly below potential of 3 percent. Inflation is seen coming in at 1-3/4 to 2 percent which is within the Fed's target range. However, what is often overlooked for these Fed forecasts is that each Fed bank is told by the Board to assume an appropriate monetary policy over the forecast period. So, we do not know whether the 2008 forecast incorporates any change in policy. We can assume, however, that the Fed is committed to reaching below 2 percent inflation in the near future - and the Fed believes that this goal can be reached while maintaining modest economic growth.

The bottom line
The economy is in transition from fairly robust growth in the fourth quarter of last year to more sustainable growth rates. Monthly numbers are uneven and even volatile as noted by Federal Reserve Chairman Ben Bernanke. Housing appears to be bottoming while manufacturing is in a soft phase. Fortunately, the consumer is holding up quite well. And inflation appears to be going according to the Fed's plan. But the Fed's plan appears to be one of vigilance and patience - monetary policy is likely to be on hold for a while.

Looking Ahead: Week of February 19 through February 23
Looking ahead, this week includes Monday off for Presidents' Day and the key inflation indicator, the CPI. Although there is nothing for the markets to forecast, on Wednesday afternoon we will get the minutes of the January 30-31 FOMC meeting and may get some insight into the latest Fed thinking. Otherwise, it is a mostly quiet week on the economic calendar.

Monday
Presidents' Day
All Markets Closed

Wednesday
The consumer price index jumped 0.5 percent in December, following no change in November. The December surge was primarily related to a spurt in oil prices. The core CPI came in at a more moderate 0.2 percent gain, following no change in November. Recently, Fed Chairman Bernanke noted that core inflation has eased but that the monthly numbers can be erratic. So, markets will be watching to see if the core number brings the trend down or not. Also, Bernanke noted some very recent improvement in the owners' equivalent rent subcomponent of the core CPI-the largest subcomponent. This series still rose 0.3 percent in January but needs to come down more for the trend in the core CPI to be within the Fed's preferred inflation range.

CPI Consensus Forecast for February 07: +0.1 percent
Range: -0.3 to +0.3 percent

CPI ex food & energy Consensus Forecast for February 07: +0.2 percent
Range: +0.1 to +0.3 percent

The Conference Board's index of leading indicators
The Conference Board's index of leading economic indicators rose 0.3 percent in December vs. a revised unchanged reading in November. This indicator has been soft for a number of months, suggesting moderation in economic growth.

Leading indicators Consensus Forecast for January 07: +0.3 percent
Range: -0.1 to +0.4 percent

Thursday
Initial jobless claims jumped a sharp 44,000 for the week ending February 10 to 357,000. According to the Labor Department, severe weather in the Midwest and Northeast only accounted for about one fourth of the spike. The consumer sector has been the key driving force behind the U.S. economy and any significant deterioration in this sector would be a problem. We would need to see several weeks of elevated jobless claims before that becomes a concern.

Jobless Claims Consensus Forecast for 2/17/07: 325,000
Range: 310,000 to 350,000