The big debate going into the week's FOMC meeting focused on whether the Fed would or would not keep "for a considerable period" in their statement. As it turned out, the Fed did keep these key four words, but they changed quite a few other words relative to the past few meetings. Fed officials are now looking at an economy that is growing at a brisk pace and one with an improving labor market. This assessment suggests a more upbeat view of the economy. The Fed's statement was also different in that it deemed the risks of disinflation and inflation as "almost equal". Because the Fed believes price pressures are extremely low, they have the luxury of leaving monetary policy unchanged "for a considerable period". Some economists are now debating whether the Fed will begin to raise their federal funds rate target in mid-2004 or later in the year. In fact, some economists are even considering that the Fed may not begin to raise rates until 2005.

What are the best predictors of Fed policy changes? The Fed will continue to focus on consumer and capital spending, but especially on the pace of employment growth. Remember the Fed has a double mandate: 1) promoting full employment through economic growth; 2) maintaining price stability. As to price stability, they will closely monitor producer and consumer prices. Commodity prices may serve as a leading indicator here.

Recap of US Markets

FOMC & economic indicators: market players have much to digest
The Dow Jones industrial average was this week's primary focus as it tested and surpassed the 10,000 level. The Dow increased the most in the week, followed closely by the Russell 2000, the S&P 500, then the Wilshire 5000. The NASDAQ composite index posted the smallest rise in the week. Barring an unexpected shock, the NASDAQ will post the best gain this year followed closely by the Russell 2000. The Dow and the S&P 500 will surely post respectable gains, but small by comparison. Keep in mind, though, that the NASDAQ suffered the most during the prior three years, so there is more to recuperate.

Treasury prices appeared to go all over the board this past week as bond investors reacted negatively to the post-FOMC statement and positively to the October 28 FOMC minutes. In addition, retail sales turned out to be stronger than expected (bad for bond prices) but consumer sentiment was weaker than expected (good for bond prices). After all was said and done, long term Treasury yields were up a few basis points relative to a week ago, but the yield on the 2-year note (and 3-month bill) fell a few basis points.

Bond investors have been reacting to the economic environment, and of course the Fed lately. But over the longer term, bond investors will be reacting to a burgeoning budget deficit. An administration official noted during the week that the FY2004 budget deficit could amount to $500 billion. This suggests a rapidly increasing supply of new Treasury securities that will be issued in the coming year. The only way that the Treasury securities will be absorbed in the market is with higher yields.

Gold prices continued their rapid climb this week as gold investors react to the continuing drop in the value of the dollar. Changes in dollar/yen were minor compared to the continued depreciation of the dollar relative to the euro. At 1.2293, the euro has appreciated 17.1 percent against the dollar since year-end 2002 and 38.2 percent since year-end 2001. Gold price changes are not all that different. The metal is up 17.8 percent since year-end 2002 and up 47 percent since year-end 2001. (Compare dollar/euro values as well as gold prices in the 'Markets at a Glance' table below.)

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

Retail sales are moderate, not robust
Retail sales increased 0.9 percent in November after remaining unchanged in October (an upward revision from a previously estimated 0.3 percent drop). In contrast to October, when auto sales declined 1.6 percent, auto sales jumped 2.8 percent in November to help boost overall retail spending. However, excluding motor vehicle sales, retail sales rose 0.4 percent in November, matching the upwardly revised gain for October. Compared with the robust pace recorded in the third quarter, sales seem almost meager by comparison. Moreover, sales were not up uniformly in November. Sales jumped at furniture stores and electronic & appliance stores, but were down at food, sport goods and department stores. In addition, gas stations sales rose 1.6 percent, just about reversing October's 1.9 percent drop. Gas station sales are primarily affected by gasoline prices. Consequently, we like to look at retail sales excluding autos and gas stations to get a clearer picture of underlying demand. Based on the chart below, October sales grew about twice as fast as November sales. Notice how much weaker sales are relative to the summer months. It is important to keep in mind that retail sales are seasonally adjusted and the seasonal factors are looking for strength in the final quarter due to normal holiday spending.

Anecdotal evidence: I would have to hand in my economist badge if I didn't reveal my personal observations during my own holiday shopping. Visiting the mall last night, my husband and I found an unbelievable amount of discounted items. Fifty percent off was the norm rather than the exception. People were spending and most stores had good traffic flow. The bargains were well worth it. If we consider the volume of sales, it looks to me that this season is progressing well. However, when one considers the unbelievable discounts available more than two weeks before Christmas, one would have to say that profit margins are suffering. Department stores must believe they need heavy discounting to sell things. That is not the sign of a robust economy. It suggests that the economy is still struggling.

Trade deficit widens
The international trade deficit on goods and services widened $0.4 billion to $41.8 billion in October after widening $1.7 billion in September. Exports rose 2.6 percent in October after a larger 2.9 percent hike in September. Undoubtedly, U.S. exporters are benefiting from the weaker dollar. Imports increased 2.1 percent in October after a 3.4 percent rise in September. Imports are rising despite the weaker dollar, which makes foreign goods more expensive to U.S. buyers. When demand for goods and services rise, it promotes increased demand for domestically produced as well as foreign produced goods.

On the export side, exports rose for all major categories (capital goods, industrial supplies & materials, autos & parts, foods & feeds), though nonauto consumer goods were an exception. On the import side, increases were recorded primarily for autos & parts and nonauto consumer goods. Capital goods were up marginally, and industrial materials & supplies decreased marginally. It's possible that importers were getting ready for the holiday season given that the bulk of the gains were in the consumer sector.

One would expect that the weaker foreign-exchange value of the dollar would lead to a narrowing of the trade deficit. However, two factors are at work that prevent this right now. First, orders are usually placed months in advance. Thus, paying for items today that were ordered several months ago costs more. That actually increases the trade deficit in the near term. In addition, while foreigners are certainly enticed to buy U.S. goods when the value of the dollar falls, their economies are not as strong as the U.S. economy. As a result, we are still likely to purchase more imports than foreigners will buy our exports. Over a longer time frame, if the value of the dollar remains weak, we should see greater export growth and some diminution in import growth.

PPI falls in November reversing some of the October hike
The producer price index fell 0.3 percent in November after jumping 0.8 percent in October. Energy prices fell 1.2 percent in November while food prices declined 0.3 percent. The food price drop is minor compared with the cumulative 3.4 percent gain posted over the two previous months. Excluding the volatile food and energy components, the PPI edged down 0.1 percent. Prices of drugs, cars and tobacco products all posted declines, helping to hold down the index. Computer prices continued their slide as they declined 1.2 percent in November and are down a whopping 16.7 percent since last November. In contrast, light truck prices rose 1 percent in November after a 3.4 percent spurt last month. New model-year cars and trucks are introduced into the PPI in October and November, and quality adjustments in vehicles often lead to price hikes in the PPI.

Prices of intermediate goods fell 0.2 percent in November, but excluding food and energy were up 0.2 percent. Intermediate goods prices are now up 3.3 percent versus a year ago, not very different from finished goods prices which are 3.4 percent higher than last November. Excluding food and energy, finished goods prices are up a slight 0.5 percent though intermediate goods are up 1.8 percent.

Crude materials prices continue to surge. Total crude goods prices were up 0.2 percent in November, but excluding food and energy, they rose a whopping 4.3 percent! On a year-over-year basis, total crude goods prices are up 18.3 percent while nonfood, nonenergy crude goods are up 17.1 percent. This surge in crude materials prices reflects expanding manufacturing activity and improved growth in industrial production. At this stage of the game, it is not reflecting worrisome inflationary pressures.

The Bottom Line
Economic news was slightly more mixed this week than last week, although on the whole, still fairly good. Retail sales turned out to be stronger than expected with upward revisions to the previous month. Nonetheless, sales were still significantly weaker than recorded over the summer months. Market players were also surprised by preliminary mid-month figures for the University of Michigan's consumer sentiment index, which turned out weaker than expected and down from the previous month. Our own view is that consumer confidence data should be taken with a grain of salt.

The Fed gave a more upbeat view of the economy in their post-FOMC statement and this turned out to be less than friendly news for financial market players. It led some economists to revise forward their expectations for a federal funds rate increase. Later in the week, the FOMC minutes from the October 28 meeting revealed that the Fed expected slack labor markets through 2005. Financial market players viewed this in a very positive light. We believe that the more recent post-FOMC statement is significantly more relevant than minutes from a meeting two months ago. The euphoria stemming from the October 28 minutes was clearly overdone by market players, although some economists went so far as to predict that the Fed would not raise rates until 2005. Go figure?

Looking Ahead: Week of December 15 to December 19

Monday
The Empire State Manufacturing index jumped to 49.1 in November from an already extraordinarily high level of 42.4 in October. New orders, shipments and inventories posted gains last month, while supplier deliveries and unfilled orders moderated their rate of growth. This index is viewed as a leading indicator of the Philadelphia Fed's business outlook survey and the ISM manufacturing index.

Empire State Manufacturing Consensus Forecast for Dec 03: 35
Range: 30 to 42

Tuesday
The consumer price index was unchanged in October after posting gains of 0.3 percent in the two previous months. A sharp 3.9 percent drop in energy prices helped hold down the index level. Excluding the volatile food and energy components, the CPI rose 0.2 percent in October after posting 0.1 percent gains in each of the two previous months. Since the Fed now claims that the risk of disinflation is roughly equal to the risk of inflation, market players will closely watch inflation indicators to get a sense of when the Fed will be ready to start tightening monetary policy.

CPI Consensus Forecast for Nov 03: 0.1 percent
Range: 0.0 to 0.2 percent

CPI ex food & energy Consensus Forecast for Nov 03: 0.1 percent
Range: 0.1 to 0.2 percent

Housing starts increased 2.9 percent in October to a 1.96 million-unit rate after rising 4 percent in September to a 1.91 million-unit rate. Strong increases were recorded among single-family homes in both months. Multi-family housing construction rose in September but fell in October. On a regional basis, gains were sharp in the South and West, although starts decreased in the Northeast and Midwest. Interest rates remain low and should help hold up housing levels; accelerating income growth could also help.

Housing starts Consensus Forecast for Nov 03: 1.91 million-unit rate
Range: 1.86 to 1.96 million-unit rate

The index of industrial production edged up 0.2 percent in October after posting a stronger 0.5 percent gain in September. Production of consumer goods and business equipment was down in October, although construction supplies and defense & space equipment production rose in October. The capacity utilization rate remains depressed by historical standards, standing at 75 percent in October.

Industrial production Consensus Forecast for Nov 03: 0.6 percent
Range: 0.3 to 0.8 percent

Capacity utilization rate Consensus Forecast for Nov 03: 75.4 percent
Range: 75.2 to 75.6 percent

Thursday
New jobless claims rose 13,000 in the week ended December 6 to a level of 378,000; this was the second increase in a row. Nevertheless, claims have remained solidly below the 400,000 mark for 10 weeks now. Keep in mind that holidays distort weekly claims figures and this season holds many holidays.

Jobless Claims Consensus Forecast for 12/13/03: 370,000 (-8,000)
Range: 350,000 to 380,000

The Conference Board's index of leading indicators rose 0.4 percent in October after showing no change in September. Six of the ten indicators posted gains in October. These include jobless claims, building permits, vendor performance, stock prices, the index of consumer expectations and the interest-rate spread. Three indicators declined: real money supply, manufacturers orders for consumer goods and nondefense capital goods. Average weekly manufacturing hours were flat. Some of the same indicators are likely to post increases in November; in addition, the manufacturing orders figures may be more positive in November.

Leading indicators Consensus Forecast for Nov 03: 0.4 percent
Range: 0.3 to 0.5 percent

The Philadelphia Fed's business outlook survey edged down to 25.9 in November from a high level of 28 reached in October. Despite the slight downtick, there is no question that this index, rising for six straight months, points to an expanding manufacturing sector. Market players often view this index as a leading indicator of the ISM manufacturing index. We find that it is a good predictor for the index of industrial production as well.