Consumers shop, inflation quiet Econoday Simply Economics 8/11/00 By Evelina M. Tainer, Chief Economist

Lazy days of summer
Markets traded in a relatively tight range this past week. Equity investors have probably come to the realization that the Fed will keep rates on hold at the August 22 FOMC meeting. Most investors also believe that Fed officials aren't likely to raise rates going into the fall election. Some equity market players might even believe the Fed's next move will be an ease, but that's somewhere in the future. So why aren't investors showing more signs of pep in the stock market? Because second quarter earnings were not stellar enough. Even companies that reported healthy earnings warned investors of softness in the second half. Equity market players have to look at two key variables , interest rates and sales revenues. While interest rates are no longer on a rising trend, softer economic growth does generally translate into weaker revenues and earnings for corporations. The focus on earnings could keep price action subdued in the next couple of months.

Supply situation keeps Treasury yields down
Economic conditions and supply of securities in the market generally affect the Treasury market. Since the beginning of this year the supply situation has dominated, holding down yields even in the face of Federal Reserve tightening. For the most part, bond investors now believe that the Fed will not only remain on hold at the August 22 FOMC meeting, but aren't likely to raise rates anymore this year as the economy could be approaching a "soft landing". Indeed, some bond market participants are even suggesting that the next rate move will be an ease, that is, a reduction in the federal funds rate target.

The Treasury surplus continues to reduce the borrowing needs of the government. This past week, the Treasury auctioned a smaller quantity of notes and bonds. In particular, the size of the 30-year bond auction was cut in half compared with the beginning of the year. In any case, auctions were generally well received, particularly the 30-year. All in all, this is helping to keep down bond yields.

Markets at a Glance
Treasury Securities	12/31/99	2000 High	2000 Low	Aug 4	Aug 11	Week % Change
30-year Bond	6.48%	6.75%	5.70%	5.71%	5.71%	0.00%
10-year Note	6.43%	6.77%	5.78%	5.90%	5.78%	-0.12%
5-year Note	6.34%	6.81%	6.01%	6.01%	6.06%	0.05%
2-year Note	6.24%	6.90%	6.13%	6.13%	6.22%	0.09%
Fed Funds Rate Target	5.50%	6.50%	5.50%	6.50%	6.50%	0.00
Stock Prices
DJIA	11497	11723	9811	10768	11028	2.4%
S&P 500	1469	1524	1348	1463	1472	0.6%
NASDAQ Composite	4069	5049	3164	3787	3789	0.1%
Russell 2000	505	606	457	504	510	1.2%
Wilshier 5000	13813	14751	12475	13616	13704	0.6%
Exchange Rates
Euro/$	1.0008	0.8893	1.0336	0.9082	0.9029	-0.6%
Yen/$	102.40	111.35	101.45	108.52	108.68	0.1%
Commodity Prices
Crude Oil ($/barrel)	$25.60	$34.05	$21.20	$29.92	$31.15	4.1%
Gold ($/ounce)	$289.60	$326.00	$273.90	$278.70	$280.50	0.6%

Consumer surprise
Retail sales jumped 0.7 percent in July after posting smaller gains or declines the previous four months. Excluding the auto group, sales rose 0.6 percent in July, twice as fast as the 0.3 percent rise recorded in each of the two previous months. The chart below shows a renewed upward trend in retail spending in July after anemic sales in the second quarter. Fed officials have harped on the issue that consumer spending needs to slow for the economy to grow at a sustainable pace. The question they have to be asking themselves is whether the July spurt is the beginning of a new boomlet or just a correction from the previous month.

It is always important to keep in mind that one month doesn't make a trend. The chart above shows that even with the little spurt in July, monthly sales growth is considerably lower than it was in 1999 and even early 2000. Looking at the composition of the retail sales growth, one is left with the feeling that consumers picked up their pace a bit in July after pretty much stalling in the second quarter , particularly on the durable goods front. For the past three months, spending on durables has held steady at 6.8 percent year-over-year growth. This is down sharply from just six months ago when the year-over-year gain in durable goods was averaging 11.6 percent in the first quarter.

Spending on nondurable goods has shown less moderation. In fact, yearly gains are still in an upward trend. But then, keep in mind that nominal spending was boosted by sharp gains in gasoline prices in the first half of the year. Excluding gas station sales, yearly gains in nondurable goods have held in a tight range between 7.6 percent and 8.1 percent for the past six months.

The bottom-line on retail sales? Retail sales were a bit of a surprise in July , growing slightly faster than predicted by economists. It is worth noting, though, that May and June sales were revised down modestly, so that the trajectory is on a slightly lower path. Moreover, the economy is in a healthy expansion. Even with moderation on the part of the consumer, we shouldn't expect significant weakness. Afterall, we are headed for a soft landing, not a recession. That said, Fed officials are not likely to raise the federal funds rate target at the August 22 FOMC meeting just because retail sales were bit stronger than expected. However, they are likely to monitor retail spending quite closely in the next couple of months and hopes that sales for the rest of the quarter will be a bit on the slower side.

Inflation remains subdued
The producer price index remained unchanged in July after rising 0.6 percent in June. Food prices were unchanged for the month, but energy prices dipped 0.7 percent. The decline in energy prices was a drop in the bucket after a 5.1 percent spurt posted last month! In fact, energy prices are still 19.2 percent higher than a year ago. The total PPI is now 4.1 percent higher than year ago levels, only a slight improvement after last month's 4.3 percent gain.

Excluding the volatile food and energy components, the PPI inched up 0.1 percent in July, reversing the previous month's drop. In the first seven months of the year, the core PPI has averaged monthly increases of less than 0.1 percent. However, the year-over-year gain is showing a slightly different picture, edging up ever so slightly each month. The yearly rise stood at 1.5 percent in July , the largest year-over-year gain since November 1999.

This slight upward drift should not be considered problematic. Prices for intermediate goods and crude materials have shown signs of moderation the past few months. From January to April, the core intermediate index (excluding food and energy) averaged monthly gains of 0.4 percent, while it only averaged monthly gains of 0.2 percent from May to July. The core index for crude materials has declined for five straight months , an average monthly drop of 1 percent. This should be comforting to Fed officials.

Other signs of relief are also evident in the import and export price indices reported by the Labor Department earlier in the week. Import and export prices were both unchanged in July. As indicated by the chart above, import prices have calmed down a bit as energy prices have started to decline. However, the 2.4 percent drop in petroleum import prices is really modest after a cumulative gain of 14.3 percent in the previous two months. And petroleum import prices are up a whopping 59.5 percent from year earlier figures. There is still room for improvement on the energy front.

The bottom-line on inflation? The producer price index was subdued , in line with expectations. Market players and government policymakers also monitor the crude materials and intermediate goods prices, not just finished goods, and had to be encouraged by the more moderate prices at earlier stages of processing. All in all, inflation news remains encouraging and should not be a concern for Fed officials when they are determining the course of monetary policy at the August 22 FOMC meeting. These figures certainly would allow them to remain on hold.

Productivity keeps on chugging
Nonfarm productivity grew at a 5.3 percent rate in the second quarter after increasing at a more moderate 1.9 percent pace in the first quarter. This follows gains of 5.2 percent and 8 percent in the third and fourth quarters of 1999 , not shabby at all. The productivity gains were somewhat better than expected but also incorporated revisions from the past several years (coming in line with the revised national income and product accounts, which showed new GDP figures a few weeks ago). Quarterly productivity factors can be skewed by special factors in employment or GDP so we like to look at the yearly trends in productivity growth. The chart below depicts the upward trend in nonfarm productivity over the past several years. It is truly amazing that productivity gains would be accelerating at this mature phase of the business cycle. One has to believe that the current pace isn't sustainable. But the improved productivity trends have certainly allowed wage gains that didn't translate into inflationary pressures for consumers.

Just as nonfarm productivity has accelerated in the past several quarters, unit labor costs have moderated. Unit labor costs edged down at a 0.1 percent rate in the second quarter after growing at a 1.9 percent rate in the first three months of the year. Yet, this translates into a 0.4 percent year-over-year drop in unit labor costs. The chart above depicts a downward trend from the peak in unit labor costs posted in mid-1998.

The bottom-line on productivity? Productivity trends reversed course in the 1990s from the more anemic pace of the previous two decades. Each quarter, economists and policymakers are amazed at the continued acceleration in productivity at this mature phase of the economic expansion. As long as productivity growth continues at a healthy clip, it will allow wages to increase without incurring inflationary costs for consumers. A year ago, Federal Reserve chairman Alan Greenspan was noting that productivity gains were not likely to continue at the same robust pace. This year, he is shifting his tune a bit, and indicating that productivity growth may continue at a healthy pace (although perhaps not as fast as the second quarter). These figures do allow Fed officials some leeway in setting the course of monetary policy this summer, and will likely keep them on hold at the August FOMC meeting.

THE BOTTOM LINE
Market players had been anxiously awaiting the retail sales figures since they know that Fed officials are counting on a slower rate of consumption growth to moderate the red-hot economy. July retail sales were somewhat stronger than expected, but follow downward revisions and soggy spending in the prior few months. The July retail sales were probably the strongest set of data coming in since the moderation in the employment situation set the tone for weaker economic reports this month.

Inflation news remains good as the producer price index was unchanged, and productivity news was on the healthy side as well. The lack of cost pressures from the PPI suggest that producers aren't like to lift product prices in the near term. Moreover, the productivity gains allow increases in wages without corresponding gains in prices of consumer goods and services.

Despite the stronger than expected retail sales figures, this week's set of economic indicators shouldn't change the view that the Fed is not likely to raise rates at the August 22 FOMC meeting. Keep in mind, though, that the Fed always looks at the whole picture. They will still have a few key reports coming in next week , consumer prices and housing starts.

Looking Ahead: Week of August 14 to August 18
Market News International compiles this market consensus which surveys about 20 economists each week.

Monday
Economists are predicting that business inventories will increase 0.6 percent in June after rising 0.8 percent in May. This reflects gains in manufacturing and wholesale trade inventories already reported for the month. (Forecast range: 3.0 to 8.0 percent)

Tuesday
The index of industrial production should increase a modest 0.4 percent in July after edging up only 0.2 percent in June. Increased factory hours worked point to the higher growth for the month. (Forecast range: 0.1 to 0.5 percent) The capacity utilization rate is expected to inch up to 82.2 percent in July, almost no change from last month. The capacity figures are not indicative of supply bottlenecks at this time, which would lead to price pressures. (Forecast range: 81.1 to 82.3 percent)

Wednesday
Economists are predicting that the consumer price index will inch up 0.1 percent in July after jumping 0.6 percent in June. Energy prices have come down modestly in the past month helping to curtail the CPI gain. (Forecast range: 0.0 to 0.3 percent) Excluding food and energy prices, the consensus forecast is calling for a 0.2 percent gain in the CPI, the same as the past several months. (Forecast range: 0.1 to 0.3 percent)

Market players are looking for a 0.5 percent rise in housing starts to a 1.56 million-unit rate in July. This is a meager rise after the past several months of declines in this indicator. At the same time, building permits are expected to rise 1 percent to 1.54 million-unit rates. Fed officials are counting on moderation in this interest-sensitive sector to slow demand in related consumer sectors such as furniture and appliance spending.

Thursday
Market participants are expecting new jobless claims to rise 2,000 in the week ended August 5 from last week's 293,000 level. Claims are likely to be rather volatile in the next several weeks since summer factory shutdown schedules are not exact from year to year. (Forecast range: -10,000 to +5,000)

The Philadelphia Fed's business outlook survey is expected to rise to 5.0 in August from a level of 0.7 in July. This index has posted levels near the zero mark over the past couple of months, indicating little growth in manufacturing in this Federal Reserve district. This index tends to be a leading indicator for industrial production. (Forecast range: unchanged to + 0.8 percent)

Friday
The consensus forecast is looking for the international trade deficit on goods and services. to widen marginally to $31.4 billion in June from a deficit of $31 billion in May. Economists are predicting a modest rise in exports, but a larger one in imports. (Forecast range: unchanged to + 0.2 percent)

The federal budget deficit is expected to amount to $5 billion in July after a $56.3 billion surplus in June. In the past four years, the July budget deficit has averaged $25 billion. (Forecast range: + 0.1 percent to + 0.5 percent)