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Inflation indicators last week painted a picture of growing pressures. Market movements during the week hinged heavily on the direction of oil prices for the day. Despite sharp volatility, oil prices remained near record highs, adding to inflation worries. Meanwhile, Fed officials – including Chairman Ben Bernanke – indicated that fighting inflation is now the top priority for the Fed. Other economic data showed the consumer sector stronger than expected, providing some positive news.
 Oil prices whipsawed this past week but netted a decline of $1.89 per barrel for spot West Texas Intermediate to settle at $134.85 per barrel.
Prices fell the most the first two days of the week, dropping $3 per barrel on Monday and $4 per barrel the following day. Monday’s drop reflected profit taking after Friday’s record high and also was in response to comments by a Saudi Arabian official that current oil prices could not be justified. On Tuesday, gains in the dollar and a report of increased production by OPEC weighed on prices.
Oil prices surged over $5 per barrel on Wednesday on news that U.S. inventories had fallen much more than expected. While prices were little-changed on Thursday, comments by the Saudi Arabian Oil Minister repeated the view that current prices are “unjustifiable” and led to a decline of almost $2 per barrel. He indicated that Saudi Arabia would be boosting production somewhat.
Despite helpful comments from Saudi Arabia, oil prices remain quite high, reflecting the view that world-wide demand is still strong. Friday’s settle at $134.85 per barrel was just $3.69 per barrel below the record $138.54 per barrel set the previous Friday.
 Equities generally were down last week with the Dow being an exception. Key factors behind the slump were hawkish Fedspeak bluntly stating there are no more rate cuts coming and that fighting inflation is the top priority, disclosure of further losses by financial firms, and continued high oil prices. However, a Friday rally helped to lessen the damage for the week.
The tone for the week was set on Monday by two Fed officials – New York Fed President Timothy Geithner and Dallas Fed President Richard Fisher. Both made comments that the Fed may have to start raising interest rates later this year. Losses by Lehman Brothers pulled down financials. Good news from McDonald’s did help the Dow but losses by Apple pulled down the techs. Tuesday was mostly down as comments from Bernanke – implying higher interest rates ahead – weighed on the markets. Techs were pushed lower after an announcement by Texas Instruments that chip sales for cell phones were slowing. The energy sector fell on a sharp $4 drop in oil prices.
The biggest drop of the week was on Wednesday with major indexes down 1-1/2 percent to over 2 percent. The big mover was a $5 per barrel spike in oil prices after oil inventories were reported down much more than forecast. The Dow lost more than 200 points for the day. Financials were hard hit by downgrades to ratings for Lehman Brothers. Thursday was up moderately on good news from strong retail sales. Wal-Mart and Best Buy stocks were key beneficiaries on the news. Markets also were given some optimism with new M&A talk from a possible purchase of Anheuser-Busch by Belgian brewer InBev. Stocks posted healthy gains on Friday despite a drop in consumer confidence. A moderate core CPI number was one of the excuses for bargain hunting even though the headline CPI was very strong and is the new focus of Fed attention. A dip in oil prices also supported the end of week rally.
Last week, major indexes were mixed as follows: the Dow, up 0.8 percent; the S&P 500, down but essentially flat; the Nasdaq, down 0.8 percent; and the Russell 2000, down 0.9 percent.
For the year-to-date, major indexes are down from year end as follows: the Dow, down 7.2 percent; the S&P 500, down 7.4 percent; the Nasdaq, down 7.5 percent; and the Russell 2000, down 4.2 percent.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
 Treasury rates were up significantly for the week, with the 2-year and 10-year yields at their highest since the first of the year.
Rates started their rise on Monday with New York Fed and Dallas Fed presidents stating that inflation is a growing concern and that the Fed may have to raise interest rates by year end. Comments after the close by Fed Chairman Ben Bernanke – also hinting at pending rate increases – boosted yields even further on Tuesday. Bernanke also noted that the risk of a “substantial downturn” had diminished.
Several factors were behind a modest easing in rates on Wednesday, including the Fed’s Beige Book describing the current economy as “weak,” comments by a European Central Bank official downplaying the likelihood of a series of rate increases by the ECB, and by flight to quality over concern about Lehman Brothers and other financial firms. But rates jumped back up on Thursday as retail sales came in very strong – at double market expectations. Rates ended the week mixed but little changed for the day on Friday.
 On the week Treasury rates were up significantly as follows: 3-month T-bill, up 14 basis points, the 2-year note, up 66 basis points; the 5-year note, up 54 basis points; the 10-year bond, up 34 basis points; and the 30-year bond, up 15 basis points.
The past week’s jump in interest rates has put many Treasury rates at their highest level since year end. Rising inflation expectations and the increased probability of rate increases by the Fed boosted yields.
This past week, inflation reports took center stage – for the CPI and for import prices. But the Fed’s Beige Book and hawkish Fedspeak also got plenty of market attention.
 Higher oil prices left their mark on consumer prices in May as the CPI spurted 0.6 percent, following a 0.2 percent increase the month before. The core rate also firmed but not as much with a 0.2 percent boost, after a 0.1 percent uptick in April.
But both the headline and core numbers have remained quite elevated this year with the overall CPI on a year-on-year basis rising to up 4.1 percent from up 3.9 percent in April. The core rate came in at up 2.3 percent. Taking into account that CPI inflation runs about a quarter percentage point higher than the Fed’s preferred inflation measure (the PCE price index), the headline trend is way above the Fed’s implicit target range of 1-1/2 to 2 percent. The core trend is right at the top of the range but with higher food and energy costs threatening to seep into the core rate.
 For the latest monthly number, energy led the May jump with a 4.5 percent surge after a 0.2 percent down tick in April. The latest increase included a 5.7 percent increase in motor fuel, a 7.9 percent spike in heating oil, and a 2.3 percent gain in piped gas & electricity costs.
The key components keeping the core rate moderate were owners’ equivalent rent, up 0.1 percent, recreation, up 0.1 percent, and medical care, up 0.2 percent. Also, new & used motor vehicles slipped 0.1 percent while apparel declined 0.3 percent.
In addition to energy, food prices are still a little toasty, posting a 0.3 percent increase for May. Also on the warm side were education & communication, up 0.4 percent, and “other,” gaining 0.4 percent.
 Import price inflation continues at a record pace. Overall import prices in May jumped 2.3 percent, putting the year-on-year pace at a record 17.8 percent. And even the non-petroleum index was up a strong 0.5 percent for the month, leaving the year-ago pace at a record 6.6 percent rate. Petroleum imports, the key instigator of price pressures in the economy, jumped 7.8 percent in the month for a year-on-year rate of 68.8 percent -- not a record but one of only a handful of plus 50 percent readings.
Higher import prices have spread beyond just petroleum. Notably, the foods, feeds & beverages index is up 13.9 percent on a year-ago basis; capital goods, 2.4 percent; automotives, up 3.1 percent; and consumer goods excluding automotives, up 3.6 percent. While the latter three may not seem too strong, they are significantly above longer-term trends – especially for capital equipment which typically has a negative inflation rate.
The export side is also showing pressure, here centered in agricultural prices which rose 0.3 percent in the month for a 33.3 percent year-on-year rise, another a record. Total export prices also rose 0.3 percent in the month with the 8.0 percent year-on-year rate topped only once in the late 80s.
The bottom line is that the U.S. is now importing inflation. This likely is one reason why Fed Chairman Ben Bernanke recently stated that the dollar should not decline further – a highly unusual comment on a topic that generally is the turf of the Treasury Department.
 Consumers are lot more willing to spend than consumer attitude surveys suggest as retail sales jumped in May – and it was not all higher gasoline prices. Overall retail sales surged 1.0 percent in March, following a 0.4 percent gain in April. Excluding motor vehicles, retail sales continued strong with a 1.2 percent surge in
April, after gaining 1.0 percent the month before. When excluding both motor vehicles and gasoline, sales posted a 1.0 percent increase, after rising 1.1 percent in April.
 For overall retail sales in May, strength was in some surprising components. A 2.6 percent price-induced spike in gasoline station sales was in line with general expectations but a 2.4 percent boost in building materials & garden equipment sales and a 1.2 percent gain in general merchandise were not. Other increases were widespread as the only major component to decline was miscellaneous store retailers.
Apparently, the income tax rebate checks – with the first round of deliveries in May – ended up in cash registers instead of paying off debt. The retail sales numbers will add some lift to second quarter GDP – but at a more moderate pace after the numbers are deflated into real terms. Nonetheless, many question whether the consumer can keep up spending growth anywhere near this pace. This is a legitimate question going forward as consumer confidence has dropped sharply.
Consumer spirits continued to sink in June with the Reuters/University of Michigan sentiment index falling to 56.7 from 59.8 in May. Worse yet, inflation expectations remain near record highs. One-year inflation expectations slipped 1 tenth to 5.1 percent while 5-year expectations were unchanged at 3.4 percent.
 The U.S. economy took another hit from higher oil prices in April as U.S. dollars flowed out of the domestic economy and into the coffers of oil producers. The U.S. trade balance in April widened sharply primarily due to a run up in oil prices, widening to $60.9 billion from a revised $56.5 billion deficit in March. In April, exports rebounded 3.3 percent but imports surged 4.5 percent. While the oil gap jumped, the nonoil gap was little changed. The oil trade gap grew to $34.5 billion from $30.2 billion in March while the nonoil deficit was unchanged at $36.1 billion in April. The jump in the oil gap was due to a spike in oil prices to $96.81 per barrel from $89.85 in March.
The gain in exports for April was broad-based but led by capital goods excluding autos. While a major part of this was aircraft, other subcomponents also were quite strong. Exports of consumer goods were robust along with automotive exports.
The latest international trade report points to both the key strength in the economy and probably the greatest source of weakness. Exports will continue to support manufacturing but that is heavily being offset by consumer budgets being constricted by high gasoline prices and by dollars flowing out of the country to pay for oil.
The Fed’s reports from the regional Fed banks paint a less rosy picture than the latest offical retail sales numbers. The Federal Reserve's Beige book prepared for the June 25 FOMC meeting reported a "weak" economy but with rising price pressures seen in food and energy sectors. Slowing was particularly notable for the consumer sector. Housing was still weak with sales and home prices still declining in most Fed Districts. Outside of the construction industry, input prices increased and some manufacturers reported being able to pass along some of the price increases. The bottom line is that Fed Districts are still reporting an overall flat economy with rising prices for inputs boosting inflation pressures. But those pressures have not yet impacted wage inflation.
The picture for economic growth is quite soft. Housing is still negative, the consumer sector has slowed, and non-residential construction has eased. But the biggest new concern for growth is from the consumer sector.
"Consumer spending slowed since the last report as incomes were pinched by rising energy and food prices. Higher energy prices also appeared to damp domestic tourism. ... Reports on overall sales of automobiles and light trucks were weak, with several Districts indicating that sales of trucks and SUVs declined. Although dealers generally struggled to move vehicles off of their lots, contacts in the Richmond, Atlanta, and Chicago Districts reported solid sales of hybrid and other fuel-efficient vehicles."
A new theme is that consumer credit is deteriorating somewhat: "Reports on lending activity varied across Districts, although reports of softening in the consumer segment persisted. ... The New York, Philadelphia, and Cleveland Districts reported increases in overall delinquencies, with respondents in New York indicating a notable rise in late payments for consumer loans. Credit quality deteriorated further in San Francisco, but began to stabilize in Chicago and Dallas. Contacts in Kansas City and Dallas expected loan quality to deteriorate going forward."
Inflation is showing up more at the input level for manufacturers while retailers have been a little more restrained in passing along higher prices except for food and energy. Recent slowing in labor markets has moderated wage growth somewhat.
The bottom line is that the Beige Book is mostly in line with recent comments by Fed officials. Reports are generally in line with recent expectations for the economy. The one area getting more attention, however, is consumer credit. We may see changes in the economic outlook if that sector weakens further.
While markets carefully tracked the ups and downs of oil prices last week, Fed officials appear to have declared victory over pending recession and have turned their attention to fighting inflation. Several key quotes emphasize this change in priorities.
Fed Chairman Ben Bernanke started off the comments this past Monday: "Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities"; "Moreover, the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations."
Bernanke appears to corroborate recent comments by other Fed officials that fighting inflation is now the primary focus. "The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation."
The Fed Chairman's comments also indicated that the Fed, indeed, realizes that it must start thinking about when to reverse recent interest rate cuts in order to fight inflation. Changes in monetary policy (interest rates) take time to have their full effect. "Because monetary policy works with a lag, policy should be calibrated based on forecasts of medium-term inflation, which may differ from the current inflation rate."
At a Fed internal conference on inflation, Dallas Fed President Richard Fisher spoke on recent trends. The key points were much of what other Fed officials have been saying recently -- the current economy has improved, the outlook for growth has softened to a mild rebound, and inflation is a bigger worry. Fisher said monetary policy needs to be "very deliberate" - implying that the Fed needs to start thinking about when to tighten interest rates.
Boston Fed President Eric Rosengren also spoke at the same conference and had similar views on the economic outlook. Additionally, Rosengren stated that it now is important to focus on headline inflation rather than core inflation – which ratches up the Fed’s level of concern since headline inflation is almost double core inflation
Federal Reserve Bank of St. Louis President James Bullard added to the growing Fed chorus. He sees no reason for further rate cuts, given that real interest rates are somewhere between zero and moderately negative. As have other Fed officials, Bullard has shifted emphasis from worrying about too weak economic growth to too high inflation. "My sense is that the U.S. economy will be able to post stronger growth in the second half of this year despite the ongoing financial turmoil, the drag from the housing sector, and rising energy prices. Meanwhile, inflation is becoming a more pressing concern as both inflation and inflation expectations are moving higher."
While Fed officials are not calling for a rebound in the second half that is robust, they clearly see monetary policy and caretaking of the credit markets as having put in motion improvement in growth later this year. And they certainly are starting to plan their moves to rein in inflation by raising interest rates either late this year or early next year.
The economy last week looked stronger than many had believed earlier this year as consumers did their part to keep the economy growing. However, fundamentals for the consumer sector still do not look that good and a sluggish second half is the more likely outcome. While core CPI inflation has not accelerated, headline inflation clearly has due to higher energy costs. With the Fed now refocusing on taming inflation, a sluggish second half may well be exactly what the Fed wants.
The week ahead gives us the key monthly update on housing – housing starts – and new numbers on inflation with the producer price report. The final market moving indicator for the week is industrial production which comes out on Tuesday.
The Empire State manufacturing index for May stayed essentially flat, slipping 4 points in May to minus 3.2 and staying near the breakeven number of zero. Other key components remained near breakeven as new orders slipped to minus 0.5 while backlog orders improved slightly to minus 4.4. But inflation was certainly on the upswing as the prices paid index jumped more than 12 points to 69.6 – a seven-year record. But prices received showed less pressure, declining more than 5 points to 15.2 to indicate that fewer manufacturers in the region are passing costs through.
Empire State Manufacturing Survey Consensus Forecast for June 08: -.50
Range: -8.00 to 2.00
Housing starts in April rebounded unexpectedly but the improvement may have reflected the fact that it is more difficult to get into single-family housing or at least merely shows volatility in multifamily starts. Starts rebounded 8.2 percent, following a sharp 13.8 percent drop in March. The April boost was led by a 36.0 percent rebound in multifamily starts as single-family starts slipped another 1.7 percent. The bottom line is that the single-family component is still in recession and with the continued heavy supply of unsold homes, there is little reason to look for recovery in that component.
Housing starts Consensus Forecast for May 08: 0.985 million-unit rate
Range: 0.900 million to 1.050 million-unit rate
The producer price index in April moderated on temporary softness in food and energy. The overall PPI posted a 0.2 percent increase, following a sharp 1.1 percent surge in March. In contrast, the core PPI rate came in with a 0.4 percent boost, following a 0.2 percent rise in March. Both the headline number and the core figure appear to have some temporary factors affecting April movement. Food came in flat while energy declined slightly. For the core, both passenger cars and light trucks rebounded from declines in March. Headline inflation was kept soft by flat food prices and a dip in energy. But we are likely to see strengthening in food and especially in energy in May.
PPI Consensus Forecast for May 08: +1.0 percent
Range: +0.3 to +1.4 percent
PPI ex food & energy Consensus Forecast for May 08: +0.2 percent
Range: +0.1 to +0.5 percent
Industrial production dropped 0.7 percent in April, following a 0.2 percent gain the prior month. The manufacturing component also dropped -- by 0.8 percent after no change in March. Utilities output fell in April while mining output advanced 0.3 percent. In a special factor, the overall April decline was led by an 8.2 percent drop in motor vehicles & parts and was due in large part to a strike and parts shortages. But excluding motor vehicles & parts, output fell 0.4 percent, following a gain of the same magnitude the prior month. Looking ahead, we are likely to get a little help from a rebound in auto production as striking workers have returned to work. But outside of exports, demand is sluggish.
Industrial production Consensus Forecast for May: +0.1 percent
Range: -0.4 to +0.3 percent
Capacity utilization Consensus Forecast for May 08: 79.7 percent
Range: 79.3 to 80.0 percent
Initial jobless claims jumped 25,000 in the week ending June 7 to 384,000 -- the highest level since late March. But the spike may be due to seasonal adjustment difficulties as the week followed the Memorial holiday week. Continuing claims, in data for the May 31 week, also rose, up 58,000 to 3.139 million for the highest level in more than 4 years.
Jobless Claims Consensus Forecast for 6/14/08: 375,000
Range: 375,000 to 395,000
The Conference Board's index of leading indicators edged up 0.1 percent in April, the second straight 0.1 percent gain. The latest numbers suggest that the economy will show anemic growth ahead – near flat – more so than experiencing outright recession. The report's coincident indicator, closely watched by the National Bureau of Economic Research, showed no growth for a second month – also corroborating a flat economy but for the current quarter.
Leading indicators Consensus Forecast for May 08: 0.0 percent
Range: -0.1 to +0.2 percent
The general business conditions component of the Philadelphia Fed's business outlook survey index has been pointing to contraction for manufacturing in the mid-Atlantic region. The business activity index has been in negative territory for six consecutive months with the May reading coming in at minus 15.6. But the decline in activity may be slowing as new orders in May showed less severe contraction minus 3.7 in May. Rising input costs are still a problem as the prices paid index rose more than 2 points in May to 53.8. Output prices have been showing less pressure, posting a 7 tenths gain to 31.6.
Philadelphia Fed survey Consensus Forecast for June 08: -10.0
Range: -20.0 to -2.2
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