BONDS
It is truly odd. The Fed raised the fed funds rate target by 50 basis points this summer and stands ready to raise the target another 25 basis points this coming Tuesday - which would bring the fed funds rate target to 1.75 percent. Aside from the 3-month bill rate which stands just a few basis points away from 1.75 percent and has increased 33 basis points since June 29, the day before the first rate hike, the Treasury yield curve shows lower rates rather higher rates over the past three months. While the Fed has tried to remove policy accommodation, the Treasury market has rallied and interest rates have declined since the beginning of summer. The lower rates on 10-year notes benefit homebuyers because mortgage rates are tied to the 10-year Treasury note. However, home equity loans and credit card rates are tied to banks' prime rate - and that has increased in tandem with the fed funds rate target by 50 basis points from 4 percent to 4.5 percent. The prime rate will rise to 4.75 percent as long as the FOMC announces a rate hike on Tuesday.

Consumers who have credit card balances or home equity loans are seeing increasing debt service payments on balances. However, since market rates have not risen, many credit card companies continue to offer incentive rates such as zero interest on balance transfers for limited periods. (I continue to receive at least 3 to 5 solicitations per week offering zero interest on balance transfers. Fed rate hikes have yet to scare credit card companies!)

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

Good CPI report for August
Once again, market players were pleasantly surprised with an inflation report in August. The CPI inched up a modest 0.1 percent for the month after edging down 0.1 percent in July. For the third straight month, the core CPI (excluding food and energy prices) rose 0.1 percent. Among major categories, apparel, transportation and recreation all posted declines for the month. The transportation drop was largely due to declines in gasoline prices - and we know this will be headed higher again. The apparel drop was also unusual, according to Labor Department officials, because sales of fall-winter clothing, which were introduced during the month, were unusually thin. Consumers were still buying spring-summer clothing (probably at a discount!). Thus, the Labor Department believes apparel figures in September may accelerate. After all was said and done, the total CPI moderated on a year-over-year basis to show a 2.7 percent gain and the core CPI inched lower to record a 1.7 percent gain.

We like to look at the CPI for goods and services separately since goods prices tend to fluctuate more dramatically from month to month - often because of fluctuating energy prices. Indeed, goods prices have moderated substantially over the past couple of months. In contrast, prices for services (which comprise nearly 60 percent of the CPI) tend to be more stable over time. In August, the year-over-year gain was 2.9 percent compared with a 3 percent rise in July.

Market players have been wondering whether or not the Fed will continue to raise the fed funds rate target in light of the friendly CPI report. The Fed knows goods prices fluctuate and looks closely at the service component - which is not showing a similar drop in the rate of inflation. The Fed has noted the current fed funds rate target suggests too much policy accommodation. These CPI figures don't disagree with that assessment.

Retail sales dip in August
Retail sales edged down 0.3 percent in August after rising 0.8 percent in July. A 1.9 percent drop in sales at motor vehicles & parts dealers accounted for the drop. Excluding autos, retail sales edged up 0.2 percent after rising an equally meager 0.3 percent in July. In August, several components posted declines for the month, including furniture & home furnishings stores, clothing & accessory stores, general merchandise stores and foods services & drinking places. Basically, the declines were in the types of stores where sales had done well in July. Stores that saw sales gains in August - such as building materials & garden equipment, food & beverage, health & personal care, gasoline stations - posted declines in July. Thus, consumers are clearly showing they simply can't afford to buy everything and are spending their money carefully. There is no question that higher gasoline prices since the beginning of the year have hampered spending on discretionary items.

Retailers are wondering how they will fare in the back-to-school season as well as the holiday season' It's a bit too soon to tell. Equity investors like to monitor consumer sentiment because they believe that consumer attitudes determine retail sales. While certainly, it is more likely that consumer spending will be strong when consumers are optimistic about the economy, monthly changes in consumer attitudes don't usually predict monthly retail sales patterns. In any case, the University of Michigan's consumer sentiment index remained virtually unchanged at the mid-September reading at 95.8 versus August's final reading of 95.9. Consumers have a lower assessment of current conditions but have higher expectations that conditions will improve in the next six months. All in all, the attitude survey did not point to any decisive conclusion whether or not consumers plan to increase spending in the near term!

Industrial production stalls
The index of industrial production inched up a tiny 0.1 percent in August after an upward revised gain of 0.6 percent in July. While manufacturing production managed to post a healthy 0.5 percent hike in August, mining production dropped 1.1 percent and utilities production fell 2.4 percent. Utilities production has declined sharply for three straight months and is down 2.5 percent from a year ago. Mining production is also 1.1 percent lower than last year, but manufacturing production is up a solid 6.8 percent from last August. Due to the declines in mining and utilities, total production is 5.2 percent higher than last August and showing a downward trend in yearly growth over the past few months.

Indeed, the capacity utilization rate also appears to have stalled at 77.3 percent after posting healthy growth between July 2003 and April 2004. A rising capacity utilization rate signals demand for greater investment spending on capital equipment as well as the potential for supply bottlenecks and inflationary pressures. The moderation in this indicator suggests that the necessity for plant and equipment spending is not accelerating. On the positive side, it also suggests that inflationary pressures are not building rapidly either.

September has not improved much from August if one is to believe the Philadelphia Fed's business outlook survey. The index moderated sharply in September from the August pace. The Empire State manufacturing survey, which measures manufacturing activity in the New York region, improved moderately. Nonetheless, the two indexes are both down sharply from July's pace even though they remain solidly above zero. This would suggest that growth is expanding but perhaps at a much slower pace. Certainly, a pick up in mining and utilities production alone would help spur the index of industrial production in September even if manufacturing moderated a bit from the 0.5 percent August pace. We have found the Philly Fed index to be a particularly good predictor of the direction of movement in the index of industrial production (although not perfect, of course).

The Bottom Line
This week's set of economic indicators showed a softer economy - both retail sales and industrial production increased at a slower pace than in July. Inflation news was quite friendly with a CPI gain of 0.1 percent in both the total and core components.

The Fed, of course, monitors more than just the latest week of economic data when making policy decisions. The FOMC is meeting next week and the market consensus suggests they will once again decide to raise the fed funds rate target by 25 basis points. This would bring the fed funds rate target to 1.75 percent, a level last seen in September of 2002. Fed bank presidents Janet Yellen and Sandra Pianalto, of San Francisco and Cleveland, respectively, have both suggested the current target is too accommodative for this stage of the business cycle.

While market players are expecting a rate hike next week, there is somewhat more controversy over further rate hikes in November and December given that economic growth has moderated. But the Fed doesn't need to predict Fed policy - they simply act at each meeting depending on their current assessment of economic conditions. Perhaps the next employment report will help market players determine whether or not the Fed rate hikes will continue unabated in the final two months of the year. The post meeting statement will likely be more meaningful to market players than the expected rate hike.

Looking Ahead: Week of Sept 20 to Sept 24

Tuesday
Housing starts jumped 8.3 percent in July to reach a 1.978 million-unit rate after declining in June to a 1.826 million-unit rate. Both single and multi-family units posted healthy gains in July after dropping in the previous month. Homebuyers are taking advantage of low mortgage rates these days.

Housing starts Consensus Forecast for Aug 04: 1.93 million-unit rate
Range: 1.85 to 2.00 million-unit rate

The Federal Open Market Committee (FOMC) is meeting today. At both the June and August meetings, the Fed raised the fed funds rate target by 25 basis points. The rate currently stands at 1.50 percent. Most market players expect the Fed to raise the funds rate target by an additional 25 basis points at this meeting.

Fed funds rate target Consensus Forecast for Sept 21 04: 1.75 percent (+0.25 percentage point)
Range: 1.50 to 1.75 percent

Thursday
New jobless claims rose 16,000 in the week ended September 11 to 333,000. Along with last week's revision, the 4-week moving average was unchanged at 338,000. The 4-week average had been on a declining trend for a while but it has stalled out lately.

Jobless Claims Consensus Forecast for 9/18/04: 340,000 (7,000)
Range: 320,000 to 350,000

The index of leading indicators edged down 0.3 percent in July after dipping 0.1 percent in June. Among components already available, the factory workweek was unchanged in August, vendor performance slipped, stock prices declined, as did consumer expectations and the spread between the fed funds rate and the 10-year note. Claims inched higher during the month but this is negative for the index. All in all, it is shaping up to be another down month.

Leading indicators Consensus Forecast for Aug 04: -0.3 percent
Range: 0.0 to -0.4 percent

Friday
New orders for durable goods rose 1.6 percent in July after gaining 1.3 percent in June. Excluding the volatile defense sector, new orders jumped 2.6 percent in July with healthy gains in primary metals, machinery, electrical equipment and transportation.

Durable goods orders Consensus Forecast for Aug 04: 0.0 percent
Range: -2.5 to +1.2 percent

Existing home sales decreased 2.9 percent in July to a 6.72 million-unit rate from a 6.92 million-unit rate in June. July sales fell sharply in the West (-6.6 percent) and South (-4.8 percent), to a lesser degree in the Northeast (-1.4 percent), and rose in the Midwest (0.4 percent).