Long and short disparity
Despite relatively healthy economic news during the week, bond investors focused on friendly inflation news and this helped to keep yields down at the long end of the market. Yields behaved differently over the yield curve as 10-year note yields dipped during the week while 2-year yields edged higher. The 2-year note is particularly attuned to changes in economic activity that would cause the Fed to change monetary policy. Bond investors don't expect changes in the near term, but given the strong economy, the likelihood of a rate hike, eventually, is high. On Friday, bond investors were particularly rattled by a spurt in the University of Michigan's consumer sentiment index, which jumped 11 points and reached its highest level since November 2000.

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

December production soggy, but quarterly path is solid
The index of industrial production inched up 0.1 percent in December after recording a solid 1 percent hike in November. Among major market groups, only materials posted a 0.4 percent gain; consumer goods fell 0.2 percent; business equipment edged down 0.1 percent and non-industrial supplies dipped 0.2 percent. Among major industry groups, manufacturing rose 0.3 percent, mining was flat, and utilities fell 1.4 percent, reversing entirely the previous month's rise. December activity was clearly anemic and disappointing, but monthly growth rates can go askew for any number of reasons. It is much better to look at a three-month average, which shows the path of production accelerating from the third-quarter pace at a pretty healthy rate.

Despite the improvement in production during the second half of 2003, investors can be reassured that these figures won't generate concerns of economic over-heating among Fed officials. The capacity utilization rate remains quite anemic, despite its rise in both the third and fourth quarters. The U.S. industrial sector has a long way to go before capacity pressures lead to price pressures. That's the good news. However, the flip side is that demand for capital equipment and structures is diminished since producers are not running up against capacity pressures. Certainly, producers do need to maintain and upgrade facilities and equipment, which may help push spending on business equipment a little higher. But a rising capacity utilization rate would generate much higher demand for plant and equipment expenditures.

Nevertheless, the outlook for near-term industrial production growth is favorable. Two key Fed surveys posted healthy gains in January and suggest that the month will show strong activity. The general business conditions component of the New York Empire State Manufacturing survey gained 3 points in January to 39.2 after recording high levels over the past several months as well. Furthermore, the general business conditions component of the Philadelphia Fed's business outlook survey (which has a longer history) jumped more than 8 points to 38.8 in January. These two surveys are not foolproof, but they do predict trends in industrial production. And they are pointing up.

International trade deficit narrows
The international trade deficit on goods and services narrowed to $38 billion in November after reaching a $41.6 billion shortfall in October. Exports gained 2.9 percent in November after a 2.8 percent hike in October. In contrast, imports decreased 0.8 percent in November, reversing part of the previous month's 2.1 percent rise. There is no question that the deficit is high by historical standards, though the November deficit was the smallest since October 2002.

The weaker foreign exchange value of the dollar is certainly helping to boost exports. However, there is a long lag period before a declining dollar value (here against the euro) will help to boost export demand. Furthermore, export demand is also affected by a country's overall growth path. The stronger the pace of economic activity, the stronger the demand for exports. One problem with our trading partners is that their economies are growing more slowly than our economy.

There is no question, however, that the improved pattern of export demand over the past year has helped boost industrial production. A persistently weaker dollar, along with improved economic activity overseas, will help the export market - and this will further boost industrial production in the U.S.

PPI and CPI rise in December, but not to worry
The producer price index rose 0.3 percent in December, regaining the amount it had declined in the previous month. Food prices inched up 0.2 percent while energy prices jumped 1.8 percent. Excluding these two volatile components, the PPI fell 0.1 percent for the second straight month. For the year as a whole, the PPI rose 4 percent, the largest yearly rise since 1990. While food prices contributed to the gain, rising 7.7 percent, energy prices rose a whopping 11.5 percent in 2003. Excluding food and energy, the core PPI increased a more moderate 1 percent for the year.

The consumer price index rose 0.2 percent in December, offsetting November's 0.2 percent drop. Food prices rose 0.6 percent in December but energy prices only inched up 0.2 percent. Excluding food and energy prices, the CPI rose 0.1 percent in December. In 2003, the consumer price index rose 1.9 percent. The core CPI has shown a more dramatic rate of moderation than the CPI in the past few years, increasing 1.1 percent in 2003, 2 percent in 2002 and 2.8 percent in 2001. Inflation in the service sector, which accounts for nearly 60 percent of the total, has moderated dramatically over the past several years.

On the whole, inflation was certainly subdued in 2003. Energy and food prices jumped in the PPI, but gains for these two volatile components were more subdued in the consumer price index. Given a high capacity utilization rate, Fed officials are not altogether concerned about a rapid acceleration in inflation in the near term. A depreciating dollar would normally be considered inflationary, but the old rule of thumb that roughly 50 percent of the dollar drop would be passed through to consumers has declined to roughly 30 percent. This means that prices for imported goods will rise less slowly than the drop in the dollar would imply, keeping inflation under control in the near term.

Soggy retail sales for the holidays
Retail sales rose 0.5 percent in December after a stronger 1.2 percent hike in November. Excluding motor vehicles, sales rose 0.1 percent in December after a 0.7 percent gain in the previous month. On the whole, retail sales weren't so bad for the quarter. They rose at a 4.4 percent rate, pretty healthy especially given the third-quarter surge of 11.5 percent. There is no doubt that heavy discounting in the retail sector reduced revenues, although from a volume perspective, sales were probably stronger than appears.

Consumers are beginning the new year on a high note. The University of Michigan's consumer sentiment index jumped more than 10 points in mid-January to reach 103.2, the highest monthly level since November 2000! Both the current conditions and expectations components posted healthy gains at mid-month. It remains to be seen whether these levels will hold for the month-end report. Nevertheless, it appears that consumer optimism is on the mend. Consumers will need to see an improving labor market in order for this spurt to hold, but at least the year is beginning on a positive note. Just a reminder: a strong monthly gain in consumer sentiment doesn't necessarily translate into strong retail sales.

The Bottom Line
Inflation news continues to be favorable and allows Fed officials to keep monetary policy in a holding pattern. Bond investors are beginning to believe Fed officials when they say that they are not likely to raise the federal funds target soon. Industrial production figures were disappointing for the month of December but the quarterly path has improved, and manufacturing indicators suggest that production is likely to improve in January and upcoming months. A weaker dollar should help narrow the trade deficit and stronger export growth will boost production as well.

Retail sales were also somewhat soggy in December but the quarterly growth rate wasn't too bad. While the January gain in consumer optimism won't necessarily translate into higher retail sales for January, a more optimistic consumer, over time, will spend more money.

While investors had a lot of economic data to mull over this past week, the upcoming week will see few economic reports. Equity investors, however, will get to monitor corporate earnings announcements.

Looking Ahead: Week of January 19 to January 23

Wednesday
Housing starts jumped 4.5 percent in November to a 2.07 million unit rate, posting the third straight monthly gain. Single family starts rose 3.3 percent to a new high at a 1.695 million unit rate. Multi family starts, after declining in October, jumped 10.6 percent for the month. Housing construction remains healthy because of a low interest rate environment.

Housing starts Consensus Forecast for Dec 03: 1.95 million unit rate
Range: 1.875 to 2.070 million unit rate

Thursday
New jobless claims fell 11,000 in the week ended January 10 to 343,000. This brought the 4-week average down to 347,500, a recent low. This points to an improving labor market, although one does need to view these data cautiously around the holidays and we have yet to see significant improvement in nonfarm payrolls.

Jobless Claims Consensus Forecast for 1/17/04: 345,000 (2,000)
Range: 338,000 to 360,000

The index of leading indicators rose 0.3 percent in November. Economists are looking for another rise in December. Several components were positive during the month, including stock prices, jobless claims, and consumer expectations. Holding down the rise in the index will be the negative impact of a drop in money supply and a shorter factory workweek.