Week ends on friendly inflation news, but Dow falls short

Light week keeps markets on track
The NASDAQ composite reached new highs today. As indicated in the chart below, this market has exhibited strong upward momentum in the past month. Other market indices have not done as well. The Dow is below its peak and has pretty much moved sideways in the past three weeks.

The S&P 500 as well as the Russell 2000 continue to underperform the other two measures. The S&P 500 has stabilized in a narrow range recently. The Russell 2000 index of small cap stocks has recovered slightly from early August, but continues to be the weakest of the group.

Bond markets try to anticipate the Fed
The weekly chart below of Treasury yields masks some of the movement that took place over the past several days. Yet, the Friday close was nearly the same as last week. Market players had little to go on this week. The worst news was the large corporate supply. Otherwise, inflation news was not as bad as expected today - which spurred a rally. This could be easily reversed next week with key economic reports showing a strong consumer sector.

PPI: worse and better than expected
The producer price index rose 0.5 percent in August after a milder 0.2 percent gain last month. This was worse than most economists and financial market players had expected as energy prices surged 3.7 percent for the month. In July energy prices jumped 3.4 percent. Food prices posted a moderate gain by comparison -- up 0.4 percent -- but reversed about half of the previous month's drop.

Excluding food and energy prices, the PPI edged down 0.1 percent, following the downward trend of the past several months. The so-called core PPI is now 1.3 percent above year ago levels. Yet, as the chart below indicates, the core component is slowing down, not accelerating its rate of growth. While it is important not to downplay the negative impact of higher energy prices, one should keep in mind that price hikes in one sector merely changes the structure of relative prices. It doesn't cause inflation to spurt on an economy-wide scale.

As market players have become more sophisticated, they now turn to the PPI at earlier stages of processing. The PPI for intermediate goods increased 0.8 percent while the PPI for crude materials jumped 4.6 percent. Again this was due to spiraling energy costs. Excluding food and energy, the intermediate goods index increased 0.2 percent. Yet, the crude materials index rose 1.8 percent. The crude materials index is more closely aligned with commodity prices -- such as the daily CRB index.

Conventional wisdom indicates that price increases at earlier stages of processing will eventually filter through to the PPI for finished goods (and then the consumer price index). Our research has shown that in fact, price gains in crude materials and intermediate goods are not always passed along. In competitive environments, when general inflation trends are low, they tend to become higher costs to producers that result in lower profit margins.

The bottom line on the PPI? The inflation news was generally favorable as the core PPI component continues to slow its rate of growth. Prices rose more dramatically at earlier stages of processing, but these price hikes are not always passed on to consumers. It could result in lower profit margins for producers, instead, as they try to maintain market share in competitive environments.

Import/export prices....it's oil again
Import prices jumped 1 percent in August after a 0.8 percent hike in July. This was entirely due to the whopping gains in the energy sector (10.9 and 11.3 percent in July and August, respectively). Excluding energy, import prices were unchanged in both months. Non-oil import prices are still 0.9 percent below year ago levels. Yet, energy import prices are 61 percent higher than last August! Export prices rose 0.4 percent as higher prices of agricultural products boosted the total. This follows sharp declines in the previous month.

The bottom line on import/export prices? While energy prices are clearly the culprit in the higher price scenario in the chart above, it is also useful to note that the trough in import prices is probably behind us. Inflation may not be in a rapidly accelerating mode, but we have seen the best inflation news already.

THE BOTTOM LINE
It was a tough week for financial market players as they came back from summer holidays. It was a light week with respect to economic news but several Fed governors and bank presidents did speak out, including Alan Greenspan. Luckily, Greenspan's remarks were limited to generalities this week, which prevented sharp market movements. Laurence Meyer had the usual hawkish remarks, while Roger Ferguson and Edward Gramlich were not quite as bearish. They mitigated some of the damage done by Meyer.

The inflation news was generally favorable. It does appear that price hikes are generally limited to the energy sector.

This week's data did not give financial market players any clue as to whether the Fed will raise rates or not at the next FOMC meeting in early October. Market players will have to wait and see as economic indicators are reported in coming weeks.

Looking Ahead: Week of September 13 to 17
We use the Market News Service survey of forecasts to describe the market consensus.

Tuesday
Economists are predicting retail sales will increase 0.8 percent in August after a 0.7 percent gain last month. Strong gains in motor vehicle sales are helping to boost the total. Excluding autos, retail sales are expected to post a more moderate (but still healthy) 0.4 percent hike in August.

Wednesday
Financial market players are looking for a rise of 0.3 percent in the consumer price index for August. At the same time, they expect the CPI excluding food and energy prices to increase 0.2 percent. The expected rise in both components would match the July pace.

Business inventories are expected to rise 0.5 percent in July, the same as in June. This incorporates the data already available for wholesale trade and manufacturing inventories.

Thursday
Market participants are expecting new jobless claims to edge up 4,000 in the week ended September 11 from last week's 286,000. The number of economists predicting this indicator has diminished rapidly these past couple of months as its volatility has increased.

The consensus forecast shows that industrial production will edge down 0.1 in August after a healthy 0.7 percent gain last month. This incorporates the sharp drop in factory payrolls reported last week. At the same time, the capacity utilization rate should decline to 80.4 percent from 80.7 percent in July.

The Philadelphia Fed's business outlook survey is expected to edge lower to 11.5 in September from the August level of 12. This series tends to mirror changes in industrial production with a one-month lead.

Friday
Financial market players are looking for a 1.9 percent drop in housing starts in August to a 1.63 million unit rate. Building permits are expected to decrease only 0.1 percent -- to a 1.64 million unit rate. Economists generally expect the higher mortgage rates to dampen housing activity.