BONDS & THE FED
Economic news was not only robust this week but bond investors also got a whiff of inflation when the CPI rose 0.5 percent for a second time in three months. While prices are not necessarily spurting every month and labor market conditions are still uncertain, bond investors are growing alarmed that Fed officials may stand ready to raise rates pretty soon. There is no question that the current set of data support a 25 basis point rate increase sooner rather than later. Such a hike is more likely now that it was three months ago. However, the jury is still out on what the Fed will actually do over the next couple of months. Economists are at odds on whether the Fed will raise rates now or in 2005. Some believe that an expected slowdown in the economy in the second half of the year will be sufficient to keep policy on hold. However, others believe that the accelerating price situation coupled with labor market improvement (should it continue in the next couple of months) will be enough to trigger a round of hikes this summer.

Changes in Fed policy during an election year are always dicey. Conventional wisdom suggests that the Fed will not raise rates going into the election. While it is true that Fed officials would like to stay out of the political fray, the Fed has indeed acted during past election years. Furthermore, the Fed would be vilified as being political if they neglected to raise rates in an inflationary environment. Most likely, though, if the Fed believes that rate hikes (one or more) are necessary, they are more likely to act sooner rather than waiting for the November election to near. Thus, if the Fed feels the need to raise the fed funds rate target by 25 basis points, it would make more sense to do that during the summer rather than the fall.

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

CPI jumps again
The consumer price index jumped 0.5 percent in March after posting a 0.3 percent gain in February and an equally large 0.5 percent hike in January. Energy prices increased the most in January (4.7 percent) but posted hefty gains in February (1.7 percent) and March (1.9 percent) as well. Food prices were moderate during this period. Excluding food and energy prices, the CPI increased 0.4 percent in March, twice as fast as the 0.2 percent gains posted in each of the two previous months. Hotel costs, apparel prices, and medical care recorded particularly outsized gains for the month.

The chart below shows the year-over-year gain in the CPI and its major components. The core CPI (excluding food and energy prices) accelerated from a 1.2 percent yearly rise in February to a 1.6 percent yearly gain in March. Apparel prices had been down 1.6 percent in February from a year ago but in March were down only 0.2 percent. About half of these major components showed price acceleration.

Until now, many analysts were not concerned about accelerating inflationary pressures. Even in the last post-FOMC statement, Fed officials indicated that deflation was nearly as likely as inflation. They will have to strike "deflation" from their statement next month, because they would look like fools if they kept it in at this point.

Retail sales spurt in March
Retail sales jumped 1.8 percent in March after an upward revised gain of 1 percent in February and an upward revised gain of 0.5 percent in January. Apart from a drop in auto sales in January, autos helped to boost total retail spending in February and March. Excluding autos, retail sales increased 1.7 percent in March, 0.6 percent in February and 1.5 percent in January. There is no doubt about it, it was a robust quarter! The chart below shows total retail sales, retail sales excluding autos, and sales excluding autos and gasoline. Each grew about twice as fast in the first quarter of 2004 than in the fourth quarter of 2003.

Given the healthy housing market, it is no surprise that building materials & garden equipment stores surged a record 10.6 percent in March while furniture stores gained 1.2 percent for the month. Clothing stores also posted a health 1.9 percent gain although given the 0.9 percent rise in apparel prices, one has to wonder if a good chunk of that wasn't due to higher retail prices. All in all, the data showed a healthy consumer.

Another housing jump
Housing starts jumped 6.4 percent in March to a 2.01 million-unit rate after declining in both January and February. Despite the March spurt, November and December 2003 levels were still higher. In fact, looking at the quarterly averages reveals that housing activity moderated in the first quarter relative to the fourth quarter. Nevertheless, we are showing our 5-month moving average chart since it best reflects housing activity, according to the Census Bureau which compiles the housing figures. The 5-month average shows that housing activity has remained roughly unchanged over the past few months with starts approaching a 2 million unit pace. Starts of single-family homes have already turned down as the level peaked in January.

Mortgage rates on conventional fixed rate loans bottomed in March with a 5.46 percent average, 23 basis points higher than the all-time low of 5.23 percent recorded last June. In the first two weeks of April, mortgage rates are up 38 basis points from the March average to 5.84 percent. With the continued improvement in economic activity coupled with fears of building inflationary pressures and an approaching Fed rate hike, Treasury yields have shot up in the past few weeks and are taking their toll on the mortgage market. This will likely hamper housing activity in the months ahead.

Indeed, the rising mortgage rates will first take a bite out of the refinancing market. The MBA refinance index was 42.6 percent lower in the week ended April 9 relative to its near term peak reached in the week ended March 19. With rising mortgage rates, refinance activity will dwindle and this will moderate the pace of discretionary income homeowners may accumulate in the near term.

Q1 Production hike
The index of industrial production edged down 0.2 percent in March after posting healthy gains in January and February. Even with the March dip, production is up solidly for the quarter. Furthermore, production accelerated for the third straight quarter, growing at a 6.5 percent rate in the first quarter. At the same time, the capacity utilization rate picked up steam to reach 76.5 in the first quarter. And for all the beating the Nasdaq composite index is taking, the fastest growth sector in production is consistently high tech. Whereas total industrial production is 3.4 percent above year ago levels, high tech production is up a whopping 26.6 percent. While the industrial production index has yet to regain the peak reached in mid-2000, production in the high tech industry regained its 2000 peak in August 2002 and now stands 38.8 percent above that level.

The outlook for April production looks good: both the Philadelphia Fed business outlook survey and the Empire State manufacturing survey posted gains in April. While one can't pinpoint the production gain based on these indexes, they usually move in the same direction on a monthly basis. Note the sharp moderation in these indexes in March, a month in which production dropped slightly.

International trade deficit narrows
The international trade deficit on goods and services narrowed in February to $-42.1 billion from January's shortfall of $43.5 billion. Exports jumped 4 percent in February after declining 1.4 percent in January. Imports increased a milder 1.6 percent in February after a slight dip in January. While export gains were strong across the board, nonauto capital goods surged, followed by industrial supplies & materials. On the import side, industrial supplies & materials increased sharply, followed by autos & parts. Imports of consumer goods excluding autos posted a drop in February.

After moderating for a bit, yearly gains in exports are now running hand in hand with yearly gains in imports. While import growth is picking up steam, it remains slower than it did in 2002 and early 2003. Export growth is now at its strongest since 2000. The weaker dollar in the FX markets is surely helping to curtail imports and boost exports these days.

The Bottom Line
Economic news was pretty good this week: retail sales surged, manufacturing surveys rose, and while production dipped in March, it surged in the first quarter as a whole. The international trade deficit narrowed. Equity and bond market players were both disconcerted by the CPI report, however, which showed signs of acceleration. Will the Fed be far behind in raising the fed funds rate target' That is the question.

The upcoming week is light on economic news. No doubt, market players will focus on Greenspan's testimony before the Joint Economic Committee on Wednesday morning. Greenspan is also testifying before the Senate Banking Committee on Tuesday but his remarks will focus on U.S. banking issues, so the Wednesday testimony will be more relevant.

Looking Ahead: Week of April 19 to April 23

Monday
The index of leading indicators was unchanged in February after rising 0.4 percent in January. Among the indicators that are available, consumer expectations, building permits and vendor performance are posting gains. Jobless claims were lower in March than in February and that adds to the leading indicators. The factory workweek, stock prices and the spread between the 10-year note and the fed funds rate was negative in March.

Leading indicators Consensus Forecast for Mar 04: 0.3 percent
Range: 0.1 to 0.4 percent

Wednesday
The Beige Book will be released on Wednesday afternoon and cover economic activity through roughly April 9th. Market players will be interested in signs of inflationary pressures, particularly since the CPI accelerated in March. Also, financial market participants will be looking for continued improvement in the labor market.

Thursday
New jobless claims jumped 30,000 in the week ended April 10 to 360,000. This brought the 4-week moving average up to 344,250 from 337,500. However, one needs to be cautious in interpreting the data since Easter is a moving holiday and seasonal adjustments are more difficult during this time of the year.

Jobless Claims Consensus Forecast for 4/17/04: 340,000 (-20,000)
Range: 330,000 to 345,000

Friday
Durable goods orders rose 2.5 percent in February, reversing the January drop. While new orders for fabricated metals fell last month, other major categories posted gains. Unfilled orders have also been on the rise, and this bodes well for industrial production.