At this time of year, no one wants to take new positions. Profit taking is the name of the game. Markets are generally thin. We will see daily fluctuations in the stock market - but probably in a tight range.

BONDS
Bond investors had to contend with 5-year and 10-year note auctions as well as corporate offerings, a fluctuating dollar and a variety of economic indicators. For the most part, the yield curve flattened. Yields on the long end came down from a week ago, while the 2-year note yield was unchanged and the 3-month yield edged up a few basis points. Market players are anticipating that the Fed will indeed raise the federal funds rate target by 25 basis points next week; this would bring the rate target up to 2.25 percent.

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

November PPI jumps more than expected
The producer price index increased 0.5 percent in November, significantly less than October's 1.7 percent hike but stronger than most economists predicted. Although energy prices posted a much smaller rise than October's 6.8 percent spurt, the 1.8 percent jump was large enough. Food prices moderated significantly, though, rising 0.4 percent after October's 1.6 percent gain. Energy price hikes are not so surprising these days. Economists and market players were more concerned with the 0.2 percent hike in the core PPI. While prices of computers fell 3.1 percent during the month, and light truck prices decreased 0.5 percent, many more components of the PPI were showing increases.

For instance, book publishing costs increased 1.3 percent; household furniture gained 1.1 percent; floor coverings jumped 2.8 percent; and passenger car prices increased 0.7 percent. Jewelry, lawn & garden equipment, and tobacco prices were higher for the month. Prices of capital equipment rose 0.2 percent after posting 0.4 percent gains in the two previous months. On the whole, capital equipment prices have increased more rapidly in 2004 than in 2003.

The chart below depicts the year-over-year changes in the PPI for finished goods. The total PPI was up 5 percent in November from a year ago, the highest year-over-year pace in 14 years! The core PPI has also accelerated over the past year to post a 1.9 percent year-over-year gain. Aside from two months ago, we last saw an increase of this magnitude in January 2001.

Economists and market players like to monitor the intermediate goods and crude goods indexes for signs of inflation at earlier stages of processing. The intermediate goods index is 9.8 percent higher than a year ago, up 8 percent when removing the volatile food and energy components. The crude materials index is up a whopping 25.5 percent from last November; it is up 25.6 percent when removing the volatile food and energy components. Prices fluctuate more dramatically at earlier stages of processing. Thus, the 25+ percent gain in the crude materials index and the nearly 10 percent gain in the intermediate goods index don't necessarily point to gains of this magnitude in the PPI for finished goods. However, in a rising rate environment where economic conditions are fairly healthy, more price hikes will pass through than if economic conditions were soggy.

This makes it crucial for Fed policymakers to stick to their current policy of removing accommodation at a measured pace. Indeed, if inflation rates step up a notch as we begin the new year, the Fed might decide to start raising the fed funds rate target at a slightly quicker pace. At some point in 2005, 25 basis-point increases could give way to 50 basis-point increases.

What's happening in the labor market'
Several market indicators give us clues on labor market conditions. Everyone tends to view the Labor Department's employment situation as the mother of all indicators. Fair enough. However, even the household and establishment survey data don't always agree each and every month about the direction of employment gains.

That's why market players and economists like to look at more than one labor market indicator. Weekly jobless claims are timely - but notoriously volatile, particularly surrounding holiday weeks. The Challenger job-cut report gives us a bead on future layoffs, but the report is not adjusted for seasonal variation. Nevertheless, the number of job-cut announcements has increased dramatically in the past few months. But the chart below suggests that this is a typical pattern for this time of year. Employers appear to announce more job-cuts in the final months of the year. It seems cruel. But actually, one of the problems with the Challenger report is that it can't separate those announcements that reflect immediate layoffs versus those that reflect long term plans where job-cuts are actually lost through attrition rather than out right firings.

In the week ended December 4, new jobless claims rose to 357,000, the second week in a row with a gain. Actually, the monthly data show a less disturbing trend. The average number of claims decreased in both October and November. The chart above attempts to smooth out monthly fluctuations. The three-month moving average shows that jobless claims have essentially stabilized at roughly 340,000 since April. A drop in new jobless claims would point to an improvement in the labor market, but at least it doesn't appear as though conditions have worsened.

The double edged sword of productivity gains
Nonfarm productivity increased at a 1.8 percent rate in the third quarter, less than half the pace recorded in the previous quarter. Quarterly productivity figures tend to be volatile, so we prefer to look at year-over-year growth in productivity. The chart below shows that indeed third-quarter nonfarm productivity growth moderated from the pace of the five previous quarters.

In reality, productivity is nearly a mathematical observation depending on economic growth and employment growth. If real GDP grew more rapidly than employment, productivity likely will have increased. When employment increases more rapidly than real GDP, then productivity gains are likely to subside. Ideally, one has the best of all worlds when real GDP growth is robust, allowing for healthy gains in employment and productivity as well.

In fact, we have seen that strong productivity growth has come about because employers have been reluctant to hire workers in the past two years. It is only within the past 11 months that nonfarm payroll employment has even posted reasonable (although not robust) gains.

Health productivity growth allows employers to raise wages without causing inflationary pressures to develop. However, as we have experienced in the past few years, productivity growth can also reduce the demand for labor when economic conditions are soggy or moderate.

Are consumer attitudes really improving'
Faithful readers of this column know my view on consumer attitude surveys! But the surveys can be helpful once users realize their drawbacks. Given the typical fascination with daily sales at retail stores around the holiday, it is worth considering if consumer sentiment is upbeat or not. The preliminary figures on the University of Michigan's consumer sentiment index showed an increase of nearly 3 points in early December to 95.7. While this would be promising (although it doesn't actually reveal anything in particular about retail spending), it is worth noting that the mid-month reading in November was also 95.5 and later revised down to 92.8 at month end. Thus, we can't really say that consumer attitudes have improved markedly in early December - because the improvement could be erased with the final reading in two weeks!

The Bottom Line
There were a lot of indicators reported this week, but Friday's PPI was the week's main event. Inflation is not spiraling out of control, but there is no question that inflationary pressures are building slowly and surely. Energy prices are the primary source of the inflationary trend. However, it doesn't help that the foreign exchange value of the dollar is depreciating rapidly - causing prices of imported goods to rise. While foreign producers often try to put a lid on price hikes in order to maintain market share - sometimes cost increases are just too large not to pass through.

The Fed considers economic conditions when making policy decisions, but there is no question that inflation is a primary factor in their deliberations. The market consensus sees the Fed raising the fed funds rate target by 25 basis points this coming Tuesday, pushing the funds rate target to 2.25 percent. It is a necessary deed but an ironic one at this time of year as consumers pile up holiday presents and new debt at the same time.

Looking Ahead: Week of Dec 13 to 17

Monday
Retail sales rose only 0.2 percent in October due to a drop in motor vehicle sales. Excluding the auto group, sales increased a healthier 0.9 percent for the month. Motor vehicle sales fell again in November, but by a smaller amount. This could help lift total retail spending. According to anecdotal reports, sales were quite robust on the day after Thanksgiving and that could give the month a boost.

Retail sales Consensus Forecast for Nov 04:-0.1 percent
Range: -0.6 to 0.5 percent

Retail sales ex autos Consensus Forecast for Nov 04: 0.3 percent
Range: -0.1 to 0.7 percent

Business inventories were unchanged in September with a drop in retail trade inventories offsetting gains in manufacturing and wholesale trade. In October, manufacturers' inventories rose 0.5 percent while wholesale trade inventories jumped 1.1 percent. This should ensure a spurt in October inventories even if retail trade inventories were to post a modest drop.

Business inventories Consensus Forecast for Oct 04: 0.6 percent
Range: 0.3 to 0.7 percent

Tuesday
The international trade deficit on goods and services narrowed in September to $51.6 billion after widening sharply in August. Still, the trade deficit has been in excess of $50 billion for four straight months through September. Not much improvement is expected through year end.

International trade balance Consensus Forecast for Oct 04: $-53.5 billion
Range: $-51 to $-55 billion

The index of industrial production increased 0.7 percent in October with healthy gains in construction supplies and manufacturing. November production is likely to have moderated based on sluggish factory hours data (from the employment report).

Industrial production Consensus Forecast for Nov 04: 0.2 percent
Range: 0.1 to 0.4 percent

Capacity utilization rate Consensus Forecast for Nov 04: 77.8 percent
Range: 77.6 to 78.1 percent

Financial market players have gone back and forth on their expectations for rate changes and wording changes. The Fed doesn't like to change rates in December because markets tend to be less liquid. Nonetheless, expectations see the Fed raising the target once again by 25 basis points. A rate change aside, the Fed's wording could steal the show.

Fed funds rate target Consensus Forecast for Dec 14 04: 2.25 percent (+0.25 percent)
Range: 2.00 to 2.25 percent

Wednesday
The New York Empire state manufacturing survey moderated sharply in October from a strong September level but then increased marginally in November. Although this series is adjusted for seasonal variation, it is unlikely to have increased much in December.

Empire State manufacturing survey Consensus Forecast for Dec 04: 20
Range: 12 to 22

Thursday
New jobless claims increased 8,000 in the week ended December 4 to 357,000 after increasing sharply in the previous week as well. The 4-week moving average inched up to 341,250. On an improving trend until two weeks ago, claims are notoriously difficult to adjust for seasonal variation at this time of year.

Jobless Claims Consensus Forecast for 12/11/04: 340,000 (-17,000)
Range: 325,000 to 350,000

Housing starts jumped 6.4 percent in October to surpass a 2 million-unit rate for the second time in three months. Mortgage rates are still low and could propel housing activity, but most economists are still expecting some moderation in the housing market in upcoming months.

Housing starts Consensus Forecast for Nov 04: 1.98 million-unit rate
Range: 1.93 to 2.03 million-unit rate

The current account deficit widened sharply in the second quarter to $166.2 billion after widening in the first quarter as well. No doubt, the $50+ billion deficits in the international trade will ensure that the current account widens even further in the third quarter. In addition to the trade balance, the current account also includes investment income and unilateral transfers.

Current account balance Consensus Forecast for Q3 04: $-171billion
Range: $-168 to $-175 billion

The Philadelphia Fed's business outlook survey moderated in November to 20.7 from a level of 28.5 in October. The general business conditions index has fluctuated sharply in recent months. In any case, it continues to show an expanding manufacturing sector.

Philadelphia Fed survey Consensus Forecast for Dec 04: 20
Range: 14.9 to 23

Friday
The consumer price index jumped 0.6 percent in October due to a surge in energy prices as well as higher food prices. Excluding food and energy, the CPI rose 0.2 percent, about in line with the past few months. The Fed and market players are more focused on potential inflation these days.

CPI Consensus Forecast for Nov 04: 0.2 percent
Range: 0.0 to 0.5 percent