Good inflation news; moderately healthy economic growth

Equity prices follow upward path
The environment for the equity market was quite favorable this week. Earnings reports were good; inflation reports were benign and economic growth was moderately healthy. One might have expected greater activity in the Dow Jones Industrials. Yet, after a move to a new record on Monday, the Dow meandered in a tight range, and managed to end the week on a higher note.

The S&P 500 and the NASDAQ composite ventured into new territory several times this week. The S&P had not increased as dramatically as the Dow in the first half of the year, so this "catch up" is not unusual. Yet, the NASDAQ continues to outperform other markets surging ever forward.

The laggard Russell 2000 index of small cap stocks is increasing on a regular basis. Yet, there is no question that the moves in the small cap sector remain modest relative to the better known blue chip and tech stocks.

Interest rates stable
Treasury securities prices increased early this week as news of financial market turmoil in Argentina led to a flight-to-quality rally. Economic news - even the favorable inflation reports - were nearly ignored. Bond markets would rally on the good news, but the higher prices didn't stick. In any case, after the long bond yield dropped 10 basis points on the Argentina news, it fluctuated in a tight 3 basis point range through the week.

Inflation remains quiescent
The consumer prices index was unchanged in June for the second straight month. This should alleviate the fears of policy-makers, market players and economists, who thought the 0.7 percent spurt in April was the beginning of the end of this virtuous cycle. Even excluding the volatile food and energy price components, the CPI increased 0.1 percent for the second straight month. The three-month and six-month growth rates in the total CPI worsened - because of higher energy prices. However, excluding these components, the rate of inflation was slower in the six months ending June (1.6 percent) than the six months ending December 1998 (2.4 percent).

The chart above shows the year over year change in the commodity and service components of the CPI. Note that the tobacco and energy spurt, which lifted the goods portion of the CPI earlier this year is now abating slightly. In addition, the service component of the CPI continues to increase at a slower rate (despite higher wages). There is just no way for the Fed to point to consumer inflation as a reason for raising interest rates at the next meeting. (They might point to something else, though.)

The producer price index also was also benign. The total PPI edged down 0.1 percent, while the PPI excluding food and energy prices decreased 0.2 percent in June. On a year-over-year basis, both were 1.5 percent higher than last June. The detailed breakdown showed that prices were generally subdued with many declines in the consumer goods and capital equipment categories. Once again, the news was truly favorable on inflation with no signs of imminent price pressures (aside from the run-up in crude oil prices in recent weeks.)

Some bears may point to the gains in intermediate and crude materials in the past few months as a negative leading indicator. Intuitively, one would expect that price hikes at the earlier stage of processing would eventually be passed on to the later stages such as the finished goods index. In reality, price increases generally occur at the same time at all levels of processing. This means that the gains in intermediate and crude materials prices may not necessarily be passed on to the PPI for finished goods. And in any case, both indices are still down from year ago levels.

Manufacturing sector is subdued
The index of industrial production rose a meager 0.2 percent in June for the second straight month. This puts production 2.7 percent higher than year ago levels. Both mining and utilities are down from a year ago, while manufacturing is 3.6 percent higher than last June. The gains are totally concentrated in the durable goods sector which is up 7.1 percent; the production of nondurable manufactured goods is down 0.7 percent from last year.

The chart above compares the monthly change in industrial production with the Philadelphia Fed's diffusion index. The Philly Fed index increased to 7.8 in July from 5.3 in July but remains at relatively low levels. Both point to relatively anemic activity in manufacturing although it is increasing (rather than contracting). The industrial sector of the economy can't be suggesting to Fed policymakers that growth is accelerating at a rapid clip. This certainly wouldn't be cause for alarm - or a potential rate hike at the next FOMC meeting in August.

Consumers still spending, albeit at a slower rate
Retail sales edged up 0.1 percent in June after a robust 1.2 percent gain in May. Excluding autos, sales increased 0.4 percent, nearly the same pace as the previous month. While retail spending was quite healthy for the quarter, the chart below shows a significant moderation from the torrid pace of the first quarter. Last week we showed the rapid growth of consumer debt. If consumers start spending just their income rather than their "paper wealth", we could see further moderation in months ahead. Yet as long as the stock market continues its upward climb, the wild consumer spending spree could continue indefinitely.

From this week's set of data, this is about the only indicator the Fed could point to as a worrisome spot for over-heating. Nonetheless, the sector did moderate from the previous quarter, so this would not make a strong case on their behalf.

THE BOTTOM LINE
This week's economic news was quite friendly for the bond and equity markets. The combination of relatively healthy economic growth with no inflation pressures once again resurrected the analogy to a Goldilock's economy.

Inflation remains quiescent in the near term. There weren't any special factors that necessarily curtailed either the PPI or the CPI. Crude oil prices have risen in the past few weeks - and this quickly leads to price hikes at the gas pump. Yet, this appears to be the only source of price hikes. Moreover, price gains are modest in the past couple of weeks. The bulk of the crude oil price jump came a few months ago. The Fed simply can't point to either of these price measures as a reason for raising rates in the near term.

Indeed, the rhetoric in the past month or so has concentrated not so much on actual price pressures, but robust growth, which could lead to inflation. The Fed will be looking for signs of moderation in the next few weeks before the next FOMC meeting. Market players are already anticipating another rate hike. Yet, a question does remain whether the Fed will raise rates at the August or October meetings. The majority are looking for a near term hike, but nothing is a done deal yet!

Looking Ahead: Week of July 19 to 23
A few key economic indicators will be reported this week. We use the Market News Service survey of forecasts to describe the market consensus.

Tuesday
Market participants expect the international trade deficit on goods and services to deteriorate in May to $19.2 billion from a shortfall of $18.9 billion in both March and April. Aircraft shipments are moderating, although it is difficult to time the actual shipments to the trade data. Import growth remains healthy from consumer and business spending.

Wednesday
Housing starts are expected to edge up 0.2 percent in June to a 1.68 million unit rate. This is a modest rise from the previous month, and keeps starts at a healthy level. Permits are expected to edge up slightly to a 1.60 million unit rate in June.

Thursday
Market participants are expecting new jobless claims to increase 20,000 in the week ended July 17 from last week's 310,000. The range for this forecast is fairly wide with a drop of 6,000 to an increase of 40,000. Less than half the survey panel is forecasting this figure.

Alan Greenspan is scheduled to address the House Banking Committee for the semi-annual Humphrey-Hawkins testimony.

The federal budget is typically in surplus in June as estimated tax payments swell government coffers. In the past two years, the budget surplus was in excess of $50 billion. Economists are looking for a similar surplus of $55 billion for the current fiscal year.