Economic news was somewhat mixed this week with stronger-than-expected as well as weaker-than- expected data that should have kept the bond market in balance. However, bond investors were entirely focused on the Fed's wording shift in their post-FOMC statement. Oddly enough, many economists and market players were expecting that the Fed would probably raise the federal funds rate target by 25 basis points at some point this summer. The new phrase allows for just that. In essence, the Fed didn't really change much - though they did remove their "considerable period" shackles. There is no question that the Fed still must wait for signs of significant and persistent improvement in the labor market before it becomes less accommodative. Nonetheless, yields surged this week as bond investors became increasingly worried that the Fed would act more quickly and more forcefully than previously thought. Notice, though, that despite the rapid gains in rates this week, yields are not as high as they were at the beginning of the month.

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

Healthy GDP growth in Q4 and 2003
The Commerce Department's first estimate revealed that real GDP expanded at a 4 percent rate in the fourth quarter after growing at a whopping 8.2 percent rate in the third quarter. This was slightly less than predicted by economists, and it disappointed market players on Friday. However, economists generally found the report to be solid since it showed healthy gains in personal consumption expenditures (2.6 percent), business fixed investment (6.9 percent), and residential investment (10.6 percent). Business inventories expanded by a moderate $6 billion dollar pace, but added to growth since inventories were still being liquidated in the third quarter. The net export deficit improved for the second quarter in a row (albeit by a minimal amount) as exports surged at a 19.1 percent rate, the fastest pace since the fourth quarter of 1996. Imports grew at a slower 11.3 percent rate. Finally, government spending increased at an 0.8 percent rate, the slowest rate in three quarters. Typically, economists and market players are much happier to see growth predominate in the private sector, thus the temporary slowdown in government spending should not be viewed in a negative light.

In 2003, real GDP grew 4.3 percent, the strongest pace since 1999 when real GDP expanded 4.7 percent. Real final sales expanded by 4.4 percent, the fastest since 1998. Given that inventory levels are low for this stage of the business cycle and final demand was healthy in the second half of last year, GDP has more room to grow in 2004.

Manufacturing sector is a mixed bag
Durable goods orders were unchanged in December after declining 2.3 percent in November. Among the major categories, new orders for machinery rose 1.7 percent and transportation orders increased 1.4 percent. The remaining components posted declines: primary metals orders fell 2.8 percent, fabricated metals orders decreased 0.8 percent and new orders for computers & electronics declined 2.7 percent (with the bulk of the drop in communications equipment as computer orders actually rose for the month). Despite the November and December weakness, new orders were on the rise in 2003 with an average monthly gain of 0.7 percent. This compares with an average monthly drop of 0.1 percent in 2002.

New orders were definitely on the mend in the second half of the year. While total new orders (excluding semiconductors) rose at about the same pace as nondefense capital goods orders in the third quarter, the fourth quarter saw more rapid growth in the total (including household goods) than for nondefense capital goods. While there is no question that durable goods orders have a long way to go before showing a healthy recovery, 2003 was a good start.

Preliminary figures suggest that manufacturing is continuing its upward trend in 2004. The NAPM-Chicago's business barometer, which measures manufacturing and non-manufacturing activity in the Chicago region, jumped to 65.9 in January, its highest level since July 1994! This indicator is considered a precursor for the ISM manufacturing index. While the two don't generally increase by the same magnitude, they often move in the same direction. Earlier in the month, two other manufacturing sector surveys, from the Philadelphia and New York Feds, also posted healthy gains in January. This bodes well for new orders and production.

Home sales strong but moderate in Q4
New home sales fell 5.1 percent in December to a 1.06 million-unit rate after declining 2.8 percent in November. Nevertheless, sales were still 0.8 percent above year-ago figures. Existing home sales posted a 6.9 percent spurt in December rising to a 6.47 million-unit rate. Sales were 8.9 percent above year-ago levels. In total, single family home sales rose in December.

Total sales dipped moderately in the fourth quarter from the third quarter peak, but there is no question that home sales surged in the second half of 2003 despite the fact that mortgage rates rose 50 basis points from their second quarter lows. It remains to be seen whether home sales will remain at current stratospheric levels or will fall back to the pace seen in the first half of 2003. January figures may not give us a good indication since extraordinarily frigid temperatures around the country may have kept prospective homebuyers indoors. Economists have been expecting at least some moderation in the frenetic pace of housing activity.

We do know that consumer attitudes improved dramatically in January (despite the snowstorms and subzero temperatures). Both the Conference Board's consumer confidence index and the University of Michigan's consumer sentiment index posted healthy gains during the month. The 11.2 percentage point hike in the University of Michigan's index was larger than the 5.1 percentage point rise in the Conference Board's index. The latter index places greater emphasis on job market questions, while the former index looks at general financial conditions. In any case, the large gains could suggest a rising trend in 2004 that could help boost overall spending. Remember, though, that a monthly rise in consumer confidence doesn't necessarily mean that retail sales will surge in the same month.

Are labor market trends improving'
Weekly jobless claims dipped a mere 1,000 in the week ended January 24 to 342,000. In the previous week, jobless claims were unchanged at 343,000. However, the average level of jobless claims for the three-and-one-half weeks of January is averaging 10,000 less than the December average. The downward trend is slow, but certainly consistent.

The Conference Board's help wanted index didn't show any improvement in December. In fact, the index dipped to 38 from 39 in November. Keep in mind, though, that this is a lagging indicator. It appears that the index hit bottom earlier in 2003. With a declining trend in new jobless claims, an increase in hiring demand should follow. An improved job market would go far in not only improving consumer optimism, but also increasing spending on goods and services. As much as market players are worried that the Fed will become less accommodative soon, the proof is in the job market.

ECI accelerates in 2003
The employment cost index rose 0.7 percent in the fourth quarter, the smallest quarterly rise than any other quarter in 2003. Wages and salaries increased 0.5 percent, and benefits costs increased 1.2 percent. In both cases, these were the smallest gains of the year. Nevertheless, the employment cost index rose 3.8 percent in 2003, faster than 2002's 3.4 percent hike. This was due to a surge in benefits costs, which jumped 6.3 percent in 2003 compared with a 5 percent rise in 2002. The 6.3 percent hike was the largest annual rise since 1990 when these costs jumped 6.7 percent. A large portion of benefits costs reflects rising health insurance premiums. Cost increases for medical care were limited during much of the 1990s but have since accelerated once again.

Wages and salaries increased 2.9 percent in both years. Wages and salaries increased at their slowest two-year rate since 1994-95 when they rose 2.8 and 2.9 percent, respectively. The slow rate of growth in wages and salaries is beneficial to employers since it helps to hold down compensation costs. However, this is not good news for workers who find themselves with limited earnings. The slow rise in wages & salaries may also force workers to spend proportionately more on nondiscretionary items. Wage and salary growth will remain depressed as long as labor market conditions remain anemic.

The Bottom Line
All in all, this week's set of economic indicators revealed that economic growth was healthy in the fourth quarter and the indicators related to January are suggesting that the economy is off to a good start in 2004. Financial market players, however, were primarily concerned with the change in the Fed's wording of the post-FOMC statement. Even though the removal of the phrase "for a considerable period" probably won't change the way the Fed conducts monetary policy (most market players had been anticipating at least a 25 basis point hike in the federal funds rate target this year), equity and bond prices tanked anyway after the announcement.

Keep in mind that the Fed won't make any significant changes in monetary policy until they see significant and persistent improvement in labor market conditions. And if employment actually begins to grow at a moderately healthy pace, gains in corporate profits will more than offset the negative impact of higher interest rates.

Several economic indicators are on next week's docket. There is no question that the employment situation (Friday, Feb. 6) could create turbulence in the markets, so buckle your seat belts!

Looking Ahead: Week of February 2 to February 6

Monday
Personal income rose 0.5 percent in November, its largest monthly gain since May. Wages and salaries, the lion's share of income, increased 0.3 percent during the month, also the largest monthly rise since May. Wages and salaries would post larger gains if employment growth improved.

Personal consumption expenditures increased 0.4 percent in November boosted primarily by a healthy 1.1 percent rise in durable goods spending. Services and nondurable goods, which account for nearly 90 percent of total consumption expenditures, each rose 0.3 percent in November.

Personal income Consensus Forecast for Dec 03: 0.2 percent
Range: -0.2 to 0.4 percent

Personal consumption expenditures Consensus Forecast for Dec 03: 0.5 percent
Range: 0.3 to 0.7 percent

The ISM manufacturing index increased moderately in December to 63.4 with gains in new orders, production, supplier deliveries and employment. Among the major components, only inventories declined - and in fact remain below the 50 percent demarcation of growth. Though employment is generally sluggish, the index was above 50 in both November and December. In December, the price index, not part of the diffusion index but nevertheless monitored closely, increased two points to 66.

ISM manufacturing index Consensus Forecast for Jan 04: 64.5
Range: 61 to 67

Construction expenditures increased 1.2 percent in November, posting a fifth straight month of 1 percent or more gains. The bulk of the strength is in the residential sector, where growth has increased by more than 2 percent in three of five months.

Construction spending Consensus Forecast for Dec 03: 0.8 percent
Range: -0.5 to 1.4 percent

Tuesday
Domestic motor vehicle sales jumped 10.4 percent in December to reach a 14.9 million-unit rate, rising to their highest level since August when cars and light trucks were sold at a 15.5 million-unit rate. In December, domestic cars were sold at a 5.8 million-unit rate; light trucks were sold at a 9.1 million-unit rate.

Domestic cars Consensus Forecast for Jan 04: 5.6 million-unit rate
Range: 5.3 to 6.0 million-unit rate

Domestic light trucks Consensus Forecast for Jan 04: 8.2 million-unit rate
Range: 7.7 to 8.5 million-unit rate

Wednesday
Factory orders decreased 1.4 percent in November after recording gains in the two previous months. While several components declined, there is no question that an 11.5 percent drop in new orders for information technology dampened factory orders in November. Durable goods orders were unchanged in December. They make up roughly half of total factory orders which include nondurable goods as well.

Factory orders Consensus Forecast for Dec 03: 0.2 percent
Range: -0.5 to +1.8 percent

The business activity index from the ISM non-manufacturing survey fell back to 58 in December November's level of 59.6 and a high of 63.8 in August. Despite the downward trend in this index, there is no question that activity remains hardy since the index stands well above 50 percent.

ISM non-manufacturing survey Consensus Forecast for Jan 04: 60
Range: 57 to 61.2

Thursday
New jobless claims fell 1,000 in the week ended January 24 to 342,000. Despite the drop, this brought the 4-week average up a tick from last week to 346,000. Nevertheless, January's average for the month is likely to be down from December's average level of 356,000. This will be the fourth straight month in which jobless claims have averaged less than 400,000.

Jobless Claims Consensus Forecast for 1/31/04: 340,000 (-2,000)
Range: 338,000 to 345,000

Nonfarm productivity surged at a whopping 9.4 percent annual rate in the third quarter while unit labor costs declined sharply at a 5.8 percent rate. The rise in productivity coupled with the drop in unit labor costs stems from the third quarter spurt in GDP coupled with the virtual standstill in employment growth. With a slower rate of growth in fourth quarter real GDP, it is likely that nonfarm productivity did not rise as quickly in the third quarter, although another dismal quarter for employment growth will help to boost the rate yet again.

Nonfarm productivity Consensus Forecast for Q4-03: 3 percent annual rate
Range: 1.9 to 7 percent annual rate

Unit labor costs Consensus Forecast for Q4-03: 0.2 percent annual rate
Range: -2 to 1.5 percent annual rate

Friday
The civilian unemployment rate fell to 5.7 percent in December. While this would normally be viewed in a favorable light, it wasn't good news because the drop was due to a decline in the labor force, not an increase in employment. Nonfarm payrolls increased 1,000 in December after a 43,000 gain in November. While one might argue that seasonal factors (in retail trade) held down November and December gains, the totals were still bleak. Manufacturing payrolls decreased 26,000 in December matching the November drop. Watch out for retail trade growth in January. When seasonals hold down retail trade in November and December, they can artificially boost this sector in January and February. That's one reason why the forecast range for nonfarm payrolls is so wide this month.

Unemployment rate Consensus Forecast for Jan 04: 5.7 percent annual rate
Range: 5.6 to 5.8 percent annual rate

Nonfarm payrolls Consensus Forecast for Jan 04: 175,000
Range: 10,000 to 300,000

Average hourly earnings Consensus Forecast for Jan 04: 0.2
Range: 0.1 to 0.3

Average workweek Consensus Forecast for Jan 04: 33.82
Range: 33.7 to 34

Consumer installment credit expanded by $4.1 billion in November, after recording a sharper $8.3 billion gain in October. The drop in motor vehicle sales in November largely contributed to the slower pace of growth. December vehicle sales surged and this should lead to another spurt in consumer credit.