No inflation, sluggish consumer Econoday Simply Economics 9/15/00 By Evelina M. Tainer, Chief Economist

Stock prices edge down on earnings fears
Typically, analysts will find different "excuses" for market movements - even when the movements are in the same direction. But every day this week, declines in stock prices (whether it was the NASDAQ composite or the Dow Jones Industrials) were attributed to the same factor: market players fear earnings will be depressed in the second half of 2000. In particular, a strong dollar versus the euro is depressing earnings of companies generating revenues in Europe. Apart from the strong dollar, economic news was favorable this week from the market player's perspective as inflation remains contained and retail sales moderated.

A spurt in oil prices coupled with a strong dollar (the euro hit a lifetime low) helped dampen stock prices across the board on Friday. Now, only the Russell 2000 and the Wilshire 5000 are at levels above those posted on December 31, 1999.

Treasury yields edge up
Economic news was relatively favorable this week from the bond investor's perspective as well, but Treasury yields backed up anyway. It appears that Treasuries took a beating at the end of the week as investors switched out of the 10-year note and 30-year bond in an effort to gain yield in long term non-Treasury issues. Market players are also somewhat concerned about rising energy prices. (Crude oil prices have risen in September even though energy prices dipped in the PPI and CPI in August.)

Markets at a Glance
Treasury Securities	12/31/99	2000 High	2000 Low	8-Sep	15-Sep	Week % Change
30-year Bond	6.48%	6.75%	5.66%	5.70%	5.90%	0.20%
10-year Note	6.43%	6.77%	5.68%	5.73%	5.83%	0.10%
5-year Note	6.34%	6.81%	5.90%	5.93%	5.91%	-0.02%
2-year Note	6.24%	6.90%	6.07%	6.09%	6.05%	-0.04%
Fed Funds Rate Target	5.50%	6.50%	5.50%	6.50%	6.50%	0.00%
Stock Prices
DJIA	11497	11723	9811	11222	10927	-2.6%
S&P 500	1469	1524	1348	1495	1466	-1.9%
NASDAQ Composite	4069	5049	3164	3979	3835	-3.6%
Russell 2000	505	606	457	536	531	-0.9%
Wilshire 5000	13813	14751	12475	14051	13813	-1.7%
Exchange Rates
Euro/$	1.0008	0.8692	1.0336	0.8692	0.8540	-1.7%
Yen/$	102.40	111.35	101.45	106.21	107.35	1.1%
Commodity Prices
Crude Oil ($/barrel)	$25.60	$35.30	$21.20	$33.70	$36.00	6.8%
Gold ($/ounce)	$289.60	$326.00	$273.90	$277.00	$275.90	-0.4%

Inflationary pressures ebb
The consumer price index fell 0.1 percent in August after rising 0.2 percent in July and 0.6 percent in June. A 2.9 percent drop in energy prices helped push down the index in August with declines in fuel oil and gasoline prices. (Labor Department officials are already warning that at least part of this drop will be reversed in September based on early energy price readings this month.) Food prices edged up modestly for the month. Excluding the volatile food and energy components, the (core) CPI increased 0.2 percent for the fifth straight month.

The chart below shows that on a year-over-year basis, the total CPI gains appear to be moderating (although they have fluctuated more wildly than usual in the past several months). In contrast, the core CPI (excluding food and energy) is moving mildly higher on a year-over-year basis. The 2.5 percent yearly rise in August is the largest since December 1998.

It's always interesting to see where price pressures are coming from…and in the case of the core CPI, it appears to be from services. The chart below compares yearly changes in goods and services. Energy prices are mostly in the goods index and the drop in energy prices over the past couple of months has helped dampen this index. The service sector is showing some gradual upward drift during 2000.

Despite the upward drift in prices of services (which is boosting the core CPI), inflationary pressures don't seem to be a major problem at this time, although these indices may keep the Fed's bias unchanged - that is, "heightened inflation risk" instead of going to a neutral bias at the next FOMC meeting.

The producer price index fell 0.2 percent in August after remaining unchanged in July. Both food and energy prices dipped during the month helping to put downward pressure on the total index. As a result, the total PPI rose only 3.2 percent on a year over year basis in August compared with a 4.1 percent yearly rise last month. Crude oil prices have risen in early September, so it is possible that we will see some more energy price hikes in the next PPI. Yet, the increase is likely to be moderate relative to the past year. We've probably seen the worst of the oil story.

Excluding the volatile food and energy sector, the PPI edged up 0.1 percent in August, the same as last month. This kept the yearly change for the core reading at 1.5 percent for the month. Notice the stability in this series on a year-over-year basis for the past several months. Indeed, tobacco prices once again were the main culprit lifting the core PPI in August.

The Labor Department's report on import and export prices showed a similar pattern in that both series are exhibiting a downward trend on a year-over-year basis. The import price index is 5.8 percent higher than a year ago (down from 6.7 percent in July); the export index is up 1.3 percent from a year ago in August, less than the 2 percent annual rise posted for July. On the import price side, this mainly reflects the mid-summer dip in oil.

The bottom-line on inflation? While Fed officials should continue to maintain the bias of "heightened inflation risks" in their FOMC announcements, the inflation indicators are showing moderating pressures. As market participants become more and more convinced that inflation is not a severe problem that will worry Fed officials in coming months, it could lead to improved prices on bonds (and lower yields). This would help the equity market to some extent, although stock investors also need revenues from strong economic growth.

Retail sales soften
Retail sales edged up a meager 0.2 percent in August after gaining 0.8 percent in July. The chart below compares the monthly changes in retail sales to their 3-month moving average. Notice how retail sales have stabilized in the past several months compared with the end of 1999 and even the beginning of this year. Excluding autos, retail sales rose 0.3 percent for the month, held down by a drop in sales at gasoline service stations. To some extent, this was probably due to the then declining gasoline prices (which were evident in the August PPI figures).

The softer trend in retail sales is also evident on a year-over-year basis. The chart below shows that retail sales peaked around the fourth quarter of 1999 (on a year-over-year basis) and have started to soften ever since. Fed officials have to be relieved at the slower pace of consumer spending.

The bottom-line on the consumer sector? Retail sales are far from dead. Consumer spending is still growing at a good clip. However, the slower pace of growth in retail sales will reassure Fed officials that economic growth is moderating and that the rate hikes of the past year are indeed having a dampening effect on economic activity.

Industrial production
The index of industrial production rose 0.3 percent in August after remaining unchanged in July. On a year-over-year basis, production is generally showing signs of moderation. For the most part, the slower sectors are consumer related - consumer goods and construction supplies. Production of business equipment continues to grow at a healthy pace. Not surprisingly, high tech is among the strongest sector. Production of computers, communication equipment and semiconductors is up 52.8 percent higher than year ago levels - the highest pace in more than five years.

While Fed officials would like to see a moderation in economic activity, increases in business equipment is considered favorable because capital spending improves the economy's productive capacity. Going forward, production is not expected to grow very rapidly. Business inventories rose 0.2 percent in July after stronger gains in the past few months. Manufacturers' and wholesale trade inventories have accelerated in recent months suggesting that some of the build-up may be unintended and could lead to some production cutbacks. In July, retail trade inventories decreased - mostly in the auto sector.

THE BOTTOM LINE
Economic activity appears to be showing signs of moderation with respect to consumer spending, but also in production. The softer pace of retail sales should reassure Fed officials that the rate hikes of the past year are indeed dampening economic vitality to some degree.

Inflation news seems favorable. The consumer price index is showing some slight upward drift in the core components, but this is probably reflecting the economic strength of the past several years. The producer price index is showing more pronounced signs of moderation and this should filter through the CPI in coming months. Nevertheless, inflation remains contained. This should keep the Fed on hold through the next several months and probably through the end of the year.

Looking Ahead: Week of September 18 to September 22
Market News International compiles this market consensus that surveys 15 - 20 economists each week.

Tuesday
Economists are predicting housing starts will rise 2.5 percent in August to a 1.550 million unit rate. This follows several monthly declines and still represents a moderation in housing activity from six months ago. (Forecast range: 1.47 million to 1.58 million unit rate) Housing permits are expected to inch up 0.9 percent in August to a 1.525 million unit rate. (Forecast range: 1.51 to 1.53 million unit rate)

Wednesday
The international trade deficit on goods and services is expected to remain virtually unchanged in July at $30.7 billion. Exports could slip a bit as aircraft shipments are down for the month. Imports could edge up slightly from higher oil prices. (Forecast range: $-29 billion to $-32.5 billion)

Market players will focus on the Beige book on Wednesday afternoon to see if anecdotal evidence shows that economic activity is moderating - particularly retail sales and housing activity. Furthermore, market participants will be watching if labor markets are becoming less tight or if wages are accelerating.

Thursday
Market participants are expecting new jobless claims to decrease 4,000 in the week ended September 16 from last week's 324,000 level. (Forecast range: -6,000 to +6,000)

Economists are predicting the Philadelphia Fed's business outlook survey will decrease modestly to 10 in September from a level of 14.1 in July. Any level over zero represents growth in production in this Federal Reserve district. (Forecast range: -2.0 to 12.5)

The consensus shows that the federal Treasury budget should record a deficit of $10 billion in August. The federal budget is still running ahead of last year in terms of the size of the budget surplus as we head towards the end of the fiscal year in September. (Forecast range: $-15 billion to $+5.0 billion)