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Last week’s economic data further raised the odds of real stagflation – and even the possibility of recession plus rising inflation. Stagflation seems like an economic nightmare raised from the dead. We were supposed to have come further along in terms of managing the economy such that the combination of anemic economic growth and higher inflation had been discarded into fading history such as from the 1970s or even mildly from the mid-1990s. But stagflation appears to be settling in at least briefly as the Fed has given fighting recession a higher priority than fighting inflation – at least for the short term. Meanwhile, stocks were mixed, interest rates mostly firmed, and oil prices eased marginally after topping the century mark.
Last week stocks were mixed as Blue Chips pulled off modest gains while Techs and Small Caps declined. Monday was an off day with markets closed for Presidents’ Day. Equities came under downward pressure on Tuesday as spot prices for crude oil prices settled over the $100 mark for the first time ever. Inflation worries threatened to push stocks down again on Wednesday after strong CPI numbers were reported early in the morning. But the afternoon’s release of Fed minutes of the January 29-30 FOMC minutes lifted most indexes smartly. Traders took heart that the Fed indicated that recession would be avoided and that there were hints of further rate cuts pending.
But Wednesday’s cheer from the Fed minutes was reversed on Thursday as the Philly Fed released a very negative manufacturing report for February, with the markets resurrecting their recession scenarios. Also, initial jobless claims remained elevated though not as high as the week before. While declines in equities were broad based, the energy sector was particularly negative as recession was seen hurting oil prices. Through most of Friday, recession worries weighed on stocks. But during the last hour of trading, stocks surged on a report that bond insurer Ambac Financial might see a bailout as soon as the following week. The financial sector especially was lifted by the news.
Last week, major indexes were mixed as follows: the Dow, up 0.3 percent; the S&P 500, up 0.2 percent; the Nasdaq, down 0.8 percent; and the Russell 2000, down 0.9 percent.
Major equity indexes still have a long way to go to recover losses since year-end levels. Major indexes are down from December 31 as follows: the Dow, down 6.7 percent; the S&P 500, down 7.8 percent; the Nasdaq, down 13.2 percent; and the Russell 2000, down 9.2 percent.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
 Treasury yields last week generally firmed slightly. A few key events were drivers in the bond market during the week. Oil prices took center stage on Tuesday as $100-plus per barrel of oil revved up inflation fears, leading Treasury rates to jump – especially for mid-range notes and bonds. Rates were mixed on Wednesday with strong CPI numbers providing upward pressure on rates while the FOMC minutes released later in the day focused more on economic weakness. A rally in Asian stocks also led to some outflow of funds from Treasuries on Wednesday. Thursday’s unexpectedly sharp drop in the Philly Fed manufacturing index pulled the rug out from under rates as recession fears were ratcheted up. At the end of the week, positive news about a likely bail out for bond insurer Ambac boosted equities and led to a mild reversal of flight to safety out of Treasuries, nudging rates up.
 Treasury yields were mostly up last week as follows: 3-month T-bill, up 1 basis point, the 2-year note; up 14 basis points; the 5-year note, up 10 basis points; and the 10-year bond, up 4 basis points. The 30-year bond was unchanged.
Despite the view that there is a greater probability of near-term recession, the Fed’s aggressive rate cutting is still bumping up inflation fears and is keeping long rates up.
 Oil prices settled over the century mark for the first time ever last week but by end of week eased on recession fears. The spot price for West Texas Intermediate broke the $100 mark for a settle price this past Tuesday, spiking $4.51 per barrel for the day to a $100.01 figure. Several factors were behind the increase including an explosion at a Texas refinery, fears that will be cutting output, and threats by Venezuelan President Chavez that he would follow through with threats to cut exports to the U.S. A new record high was set again on Wednesday with a $100.74 per barrel settlement price. Many saw the claimed reasons for the gain as not very sound – including more threats from Chavez, fears that lower interest rates would lower the dollar, and more concern over the possibility of production cuts by OPEC. Prices dropped $2.24 per barrel to $98.50 after the very negative Philly Fed manufacturing report led traders to focus on the probability of recession in the U.S. Prices nudged up on the last day of the week as Turkish troops crossed into Iraqi territory and assaulted Kurdish militants.
The spot price for West Texas Intermediate jumped $3.46 per barrel net for the week to settle at $98.96 per barrel, $3.46 below the record high of $100.74 set on Wednesday of the week.
This past week the double specter of stagflation reared its head noticeably. Consumer price inflation appears to be worsening rather than getting better. Manufacturing may now be in a mild recession along with the deep recession in housing. It is not likely that the economy was in recession as of January – but early data for February indicate it may have started this month. Meanwhile, the Fed appears poised for another interest rate cut in March to help ensure that the economy is merely in a period of slow growth rather than outright decline.
 The Fed has been forecasting that weak economic growth will lead to lower inflation. But as of January, the inflation numbers are headed in the wrong direction – up. And this is likely to limit how much the Fed can cut interest rates. The CPI rose an uncomfortable 0.4 percent for a second straight month, putting the year-on-year rate at 4.3 percent -- the highest level in 2-1/2 years. The markets could overlook this pressure were it not for a 1 tenth increase in the core rate to 0.3 percent -- the highest reading in a year-and-a-half -- which brings the year-on-year rate for this reading to 2.5 percent and its highest level in a year.
Food and energy costs were both up 0.7 percent in the month. This is bad news for the consumer who is struggling with basic bills not to mention the jobs market. Other categories showed wide increases especially transportation and medical care which were both up 0.5 percent.
The year-on-year rates of 4.3 percent and 2.5 percent for headline and core CPI inflation, respectively, are well above the Fed’s implicit target of 1-1/2 percent to 2 percent inflation for the personal consumption expenditure price index which tends to run about a quarter percentage point lower than for CPI inflation.
 Housing starts bounced up in January but remain badly depressed, rising 0.8 percent to a 1.012 million annual rate that is down 28 percent on a year-on-year basis. But starts can be sharply affected by small changes in winter weather from the norm and permits may give a better picture of the housing market during winter months. Permits in January slipped 3.0 percent for a 33 percent year-on-year decline.
By components, single-family starts fell 5.2 percent in the month to a 743,000 unit rate, offsetting a 22 percent jump in multi-family starts to a 269,000 rate. Overall, starts remain quite depressed despite a bump up in January and continued overhang of unsold new and existing homes suggest that the trend in starts is still downward.
 The Conference Board’s composite index of leading indicators fell for a fourth consecutive month in January, slipping 0.1 percent – the same as in December. Weakness in the latest month was led by a decline in stock prices and a dip in building permits. Some economists suggest that the four consecutive declines “clinch” the fact that the U.S. economy is headed into recession. Certainly, these declines have raised the odds of recession but the traditional “3-month rule” for declines leading to recession does not always hold true.
The better view is that a combination of depth, diffusion, and duration is a more appropriate method of viewing this index. That is, one should look at the size of the decreases in the leading indicator index, how many components have fallen, and for how long the index has been falling. While the index did fall notably in August, October, and November, these were interrupted in part by a moderate rise in September. Also, the declines in December and January were very modest. According to the number of components declining, over the last six months, in only three of those months did more than half of the components decline. In the latest month, only four of the ten components fell. While the leading index is pointing to recession, it is not compelling yet.
What about the question of whether we are in recession yet? The National Bureau of Economic Research (NBER) – a nonprofit private research group – officially determines business cycle dates, including the start and end of recession. While their methodology is somewhat flexible, NBER economists heavily rely on the Conference Board’s composite index of coincident indicators. These are indicators that coincide with the economic cycle rather than leading or lagging. The four components are payroll employment, personal income less transfer payments, industrial production, and business sales. The latest numbers for the coincident index show a 0.1 percent increase for both December and January. So, according to the latest data that most directly affect whether the U.S. economy is officially in recession, it is not – at least as of January.
But more recent data strongly hint that there is a significant chance a recession might be starting in February.
 Giving the strong CPI report some strong competition for the worst economic news of last week was the Philadelphia Federal Reserve's regional manufacturing report shows in February. The business activity index plunged to minus 24.0 from minus 20.9 the month before. New orders remained negative for a second month at minus10.9 versus January's minus 15.2.
 The Federal Reserve believes weak business activity will lead to less price pressure, but there is barely the slightest indication of that so far as both prices paid (46.6 in February versus 49.8 in January) and prices received (24.3 in February versus 32.0 in January) remain extremely elevated. According to the report: "Despite reporting weakness in activity, firms continued to report a rise in prices for inputs and their own manufactured goods."
The bottom line is that the Philly Fed report points to the Fed’s quandary of trying to prevent recession without stoking the flames of inflation down the road.
The minutes of the Fed’s January 29-30 policy meeting indicate that the Fed currently is more concerned about easing credit market illiquidity and preventing recession than is worried about inflation being too high. Nonetheless, Fed officials are looking over their collective shoulder that inflation pressures could be popping back up later this year. The latest policy session produced a 50 basis point rate cut and raised expectations for more. Expressing concern that GDP and the labor market may slow more than expected, FOMC members agreed at the meeting that further easing, and significant easing, could well be needed in coming months. Currently, the fed funds futures market is pricing in a 50 basis point cut in the fed funds target rate at the Fed’s March 18 policy meeting.
With the minutes of the January meeting, the Fed released it latest quarterly forecast for the economy. The Fed lowered its forecast for real GDP growth in 2008 by half a percentage point to a range of 1.3 to 2.0 percent, fourth-quarter-over-fourth quarter. But the Fed acknowledged that inflation is more of a problem than believed just last fall. The Fed raised its forecast for headline PCE inflation by three-tenths of a percentage point for 2008 to a range of 2.1 to 2.4 percent, meaning the Fed needs slower economic growth to last longer to pull inflation down in 2009. The Fed essentially is forecasting moderate stagflation for 2008 and is hoping for inflation to ease enough late in the year to allow a pickup in real growth.
While official data suggest no recession through January, the economy may be slipping closer to a mild recession as the Philly Fed manufacturing index fell deeper into negative territory, housing starts remained depressed, and the index of leading indicators slipped for the fourth month in a row. Meanwhile, higher energy prices pushed up consumer inflation. The Fed is still forecasting that a slower economy will nudge inflation down, but in coming months, the economy is stuck with at least mild stagflation as economic growth stagnates and inflation remains elevated. The key question is whether the Fed’s forecast will hold true further out – one in which inflation has eased by 2009 and economic growth has rebounded. There is a moderate chance that the Fed’s forecast meets reality but there is still a notable chance that growth could remain sluggish into 2009 if the Fed sees inflation as re-emerging and forces interest rates back up.
This coming week we get several market moving indicators, covering inflation, manufacturing, the consumer sector, as well as the overall economy. The market moving indicators include producer prices, durable goods orders, GDP, and personal income. We also get important updates on the housing sector with the existing homes sales and new home sales reports and with quite a few other second tier indicators.
Existing home sales declined another 2.2 percent in December to a 4.89 million annual rate, setting a new low for the nine years of data in the series. December sales dipped across regions. Year-on-year sales for the nation were down 22 percent at year end. One small bright spot in the latest report was that supply edged back down to 9.6 months from 10.1 months in November. A year-ago supply was 6.6 months, a time when sales had already been on a long descent from September's 2005 peak rate of 7.21 million. However, the latest improvement may be little more than home sellers losing hope and taking homes off the market. For the supply improvement to be meaningful, we need to see both a rise in sales and a decline in supply.
Existing home sales Consensus Forecast for January 08: 4.84 million-unit rate
Range: 4.65 to 4.95 million-unit rate
The producer price index slipped 0.1 percent in December, following a 3.2 percent surge in November. We also got good news last month on the core rate which moderated to a 0.2 percent increase, following a 0.4 percent jump in November. The headline number got some help from the energy component, passenger cars, and light trucks-all of which declined. But more recently energy costs have been rising and the trend for both headline and core PPI inflation is up. The year-on-year rate for the overall PPI is still quite steep, coming in at up 6.8 percent in December with the core rate also on the high side at up 2.1 percent.
PPI Consensus Forecast for January 08: +0.3 percent
Range: 0.0 to +1.1 percent
PPI ex food & energy Consensus Forecast for January 08: +0.2 percent
Range: 0.0 to +0.5 percent
The Conference Board's consumer confidence index slipped to 87.9 in January from 90.6 in December. The breadth of the decline in confidence seems to be widening. For the latest month, jobs were increasingly seen as hard to get. The readings are more negative for current and future business conditions and for future job and income readings. Buying plans for houses remain very weak though buying plans for vehicles and appliances improved with the latter possibly reflecting lower interest rates. Further weakness in the stock market as well as higher oil prices are likely to weigh on confidence in February.
Consumer confidence Consensus Forecast for February 08: 81.3
Range: 78.0 to 87.5
Durable goods orders in December came in surprisingly strong, surging 5.2 percent in December, following a 0.5 percent rise in November. December's jump in orders was led by aircraft but strength was notable in many components. Even excluding the transportation component, new orders advanced a robust 2.6 percent in December, following a 0.4 percent fall in November. But the durable goods orders series is notoriously volatile and a large swing one month is usually following a swing in the opposite direction the next month and the market consensus expects that to happen for the January numbers. In particular, aircraft orders are expected to come off a December surge.
New orders for durable goods Consensus Forecast for January 08: -3.5 percent
Range: -7.0 percent to +1.0 percent
New home sales dropped a monthly 4.7 percent in December to an annualized sales pace of 604,000, putting the year-on-year decline at 22 percent. The supply of unsold homes edged up to 9.6 months, up from 9.4 months in November and the worst reading in 27 years.
New home sales Consensus Forecast for January 08: 0.600 million-unit rate
Range: 0.580 million to 0.630 million-unit rate
GDP growth slowed sharply in the final quarter of 2007, easing to an annualized 0.6 percent, following a robust 4.9 percent surge in the third quarter. In contrast, higher oil prices led to a jump in the GDP price index to an annualized 2.6 percent, following a 1.0 percent rise in the third quarter. A new focus of the Fed, the overall PCE price index jumped to an annualized 3.9 percent from 1.8 percent in the third quarter. The core PCE price index also quickened but not as much, rising an annualized 2.7 percent in the fourth quarter, after increasing 2.0 percent the prior quarter. While the fourth quarter numbers are a little dated, markets will continue to look at the real GDP figures for any notable imbalances and whether the low number gets revised down into negative territory – which is possible given the size of average revisions. But for now, the markets are expecting an incremental upward revision to GDP growth for the quarter.
Real GDP Consensus Forecast for preliminary Q4 08: +0.7 percent annual rate
Range: +0.5 to +2.6 percent annual rate
GDP price index Consensus Forecast for preliminary Q4 08: +2.6 percent annual rate
Range: +2.6 to +2.7 percent annual rate
Core PCE price index Consensus Forecast for preliminary Q4 08: +2.6 percent annual rate
Range: +2.5 to +2.7 percent annual rate
Initial jobless claims Jobless claims fell 9,000 in the week ending February 16, but the 349,000 level is still on the high side and points to softer labor conditions. There were no special factors in the latest week. The four-week average more strongly indicates the weaker labor market with an increase of 10,750 to 360,500 and the worst level since the aftermath of Hurricane Katrina in 2005. Continuing claims were up 48,000 to 2.784 million and are at the worst level since Katrina.
Jobless Claims Consensus Forecast for 2/23/08: 350,000
Range: 345,000 to 360,000
Personal income in December rose 0.5 percent, following a 0.4 percent boost in November. Within personal income, the all important wages and salaries component advanced 0.4 percent, following a 0.6 percent increase in November. But more recently, payroll employment fell 17,000 in January while the average workweek slipped to 33.7 hours from 33.8 hours in December. These declines plus a more moderate 0.2 percent rise in January wages indicate there should be some weakening in income growth for the month. On the spending side, consumer expenditures slowed to a 0.2 percent rise after November's sharp 1.0 surge. There is a chance that December’s slowing was just a timing issue of evening out the jump in November but January retail sales numbers suggest further slowing in the month. While auto sales were moderately healthy, other components were quite sluggish outside of gasoline sales. Excluding both motor vehicles and gasoline, retail sales were flat in January. On the inflation front, the overall PCE price index increased 0.2 percent in December, after surging 0.6 percent in November. The core PCE price index held steady at 0.2 percent in December. But the latest CPI report points to stronger PCE price inflation in January as energy prices led to a 0.4 percent boost in headline inflation while the core rate came in at an uncomfortably warm 0.3 percent increase.
Personal income Consensus Forecast for January 08: +0.2 percent
Range: +0.1 to +0.6 percent
Personal consumption expenditures Consensus Forecast for January 08: +0.2 percent
Range: 0.0 to +0.4 percent
Core PCE price index Consensus Forecast for January 08: +0.3 percent
Range: +0.2 to +0.3 percent
The NAPM-Chicago purchasing managers’ index fell back about 5 points to 51.5. But the new orders index is pointing toward a likely further decline in the overall index in February as January new orders dropped from 56.7 in December to a very weak 44.7 in January - a sub-50 reading that indicates month-to-month contraction. Backlog orders also fell badly, down more than 12 points to 48.0.
NAPM-Chicago Consensus Forecast for February 08: 50.0
Range: 47.0 to 53.0
The Reuter’s/University of Michigan’s Consumer sentiment index slowed abruptly in the mid-February reading, to 69.6 from 78.4 in January. The latest reading is the worst since the 1991 recession. Declines were posted for current conditions and especially for expectations which fell nearly 10 points to 59.4. The expectations index, a key reading that often leads the overall index, is also at its lowest point since the 1991 recession. But perhaps the worst news is a nasty 3 tenth spike in one-year inflation expectations to 3.7 percent. The Fed has been counting on inflation expectations to remain "anchored" but the latest report suggests that may be slipping. Nonetheless, five-year inflation expectations are unchanged at 3.0 percent.
Consumer sentiment Consensus Forecast for final February 08: 70.0
Range: 67.8 to 72.6
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