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While markets were ecstatic about another large net decline in oil prices, the consumer sector continued to soften, pointing to a sluggish second half for the U.S. economy.
 Equities were volatile this past week but ended with a huge rally on Friday and with large net gains for the week. Many indexes were at highs not seen in over six weeks. Several key themes stood out. Sharply lower oil prices were the main factor behind the week’s gains. The spot price of crude oil fell $3.94 the last day of the week but dropped a net $8.95 for the week. The lower (that is, less high) oil prices were seen as helping consumers, putting a little more discretionary income back in their pockets and even allowing for a little more driving around money to go shopping. Lower oil prices also helped transports – notably the airlines, truckers, and shippers.
Equities were relieved by the Fed’s decision at Tuesday’s FOMC meeting to remain in “pause” mode, keeping the fed funds target rate at 2 percent. Many analysts lowered their expected trajectory for Fed rate increases – both putting off when the upward cycle begins and making it more gradual. The week’s biggest day of the week actually was Tuesday for most equity indexes due to the Fed decision but also because of a drop in oil and a better-than-expected ISM non-manufacturing index.
Financials remained a concern throughout the week. In particular, Freddie Mac reported greater-than-expected losses and Fannie Mae warned of larger credit market losses ahead. Many analysts are calling for further declines in housing prices which in turn will create further credit losses. Also weighing on financials this past week were separate announcements by Citigroup and Merrill Lynch that they would be buying back auction-rate securities that turned out to not be as liquid as promised and were not as safe as promised. It is generally believed that the firms were aware of the developing credit market freeze but continued to claim that auction-rate securities were liquid and safe.
Finally, concern about the consumer section has never drifted too far from center stage. Weekly retail sales showed deterioration in sales growth or outright declines. Wal-Mart even warned that it was seeing an end of the effects from income tax rebate checks. But as mentioned earlier, the markets see hope that lower oil prices will help the consumer sector. In fact, the lower oil prices on Friday lifted many firms in the consumer discretionary sector. But consumers remain value conscious for now. A key gainer last week was McDonald’s which posted strong sales gains. Strength, however, was also bolstered by overseas sales – an increasingly important facet of revenue growth for many companies.
Equities were up sharply this past week. The Dow was up 3.6 percent; the S&P 500, up 2.9 percent; the Nasdaq, up 4.5 percent; and the Russell 2000, up 2.5 percent.
For the year-to-date, major indexes are down as follows: the Dow, down 11.5 percent; the S&P 500, down 11.7 percent; the Nasdaq, down 9.0 percent; and the Russell 2000, down 4.1 percent.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
 Treasury yields were essentially unchanged net for the week although yields showed moderate swings on Thursday and Friday. Yields dropped somewhat on Thursday due to several factors. Jobless claims were up sharply. The Treasury’s auction of 30-year T-bonds went better than expected. And a spike for the day in oil prices led funds out of equities and into Treasuries. Finally, AIG reported a larger-than-expected loss, creating some flight to quality.
 Most of Thursday’s movement was reversed the next day as a jump in the dollar pushed oil prices down sharply. The drop in oil resulted in a big stock market rally, draining funds from bonds. The boost in the dollar over the week was sizeable, leading the dollar to a five month high against the euro. Demand for the dollar had been boosted by the European Central Bank and the Bank of England holding their benchmark interest rates steady at 4.25 percent and 5 percent, respectively. Stalling economic growth in Europe is now seen as leading to the central banks being less aggressive in raising interest rates to combat inflation.
For this past week Treasury rates were mixed as follows: 3-month T-bill, up 3 basis points, the 2-year note, down 1 basis point; the 5-year note, down 2 basis points; the 10-year bond, down 2 basis points; and the 30-year bond, down 3 basis points.
Oil prices dropped sharply last week, falling four of the five trading days. A miss of most offshore Texas oil facilities by Tropical Storm Edouard started the week off with a sharp drop in prices. On Tuesday, the Fed’s holding rates steady with a weak economy balanced against inflation concerns was seen by some as indicating weaker demand for oil ahead. Weak economic data from Europe added to the view that demand is softening.
Crude prices firmed somewhat on Thursday due to supply concerns caused by an announcement that repairs to a Turkish pipeline would take longer than previously expected. Those worries reversed on Friday as those supplies were successfully rerouted. The big mover for the day, however, was a sharp gain in the dollar after the ECB and Bank of England failed to raise interest rates. The spot price of West Texas Intermediate fell a whopping $3.94 per barrel for the day to $116.15 per barrel. This left the spot price 20.1 percent below the record high set in early July.
Net for the week, spot prices for West Texas Intermediate dropped a sharp $8.95 cents per barrel to settle at $116.15 – and coming in $29.14 below the record settle of $145.29 per barrel set on July 3.
The economy remains quite sluggish despite the euphoria in the equity markets. In particular, there are signs that the consumer sector is softening further.
 The latest personal income report points toward problems ahead for the consumer sector as income tax rebate money has about run out and the labor markets have weakened further. Meanwhile, headline inflation has worsened but perhaps slippage in oil prices will help in coming months.
Personal income growth in June decelerated after a sharp boost in May-primarily due to a drop off in income tax rebates. Personal income in June edged up 0.1 percent, following a 1.8 percent surge in May.
Overall personal income growth was slowed considerably by a drop in the level of income tax rebate checks. The stimulus program boosted the level of personal current transfer receipts by $149.4 billion (at an annual rate) in June but this was down from $179.6 billion in May. The majority of rebates were sent during the initial round of payments, which began April 28, 2008, and continued on a weekly basis through mid-July 2008. The bottom line is that we have already seen the primary impact of the rebate checks and little impact will occur after July.
The consumer sector is losing steam on the income side in a critical area – payroll income. The wages and salaries component of personal income eased to a 0.2 percent gain, following a 0.3 percent boost in May. With rising inflation, real spending power for the consumer is slipping.
Consumer spending remains strong in current dollars but spending health is now mostly an illusion created by higher prices. Personal consumption in June posted a 0.6 increase after surging 0.8 percent in May. But spending was led by a 1.3 percent boost in nondurables which includes gasoline. Essentially June's gain was due to a spike in gasoline prices as overall real spending slipped 0.2 percent, following a 0.3 percent rise in May.
 Turning to inflation, the headline PCE price index worsened even more to a 0.8 percent gain after jumping 0.5 percent in May. The core PCE price index also firmed in June, increasing 0.3 after a 0.2 percent rise in May. With the recent decline in oil prices, we are likely to get a little help with headline inflation numbers. However, the level for energy costs is still high and a considerable portion of those costs are likely still trickling into core inflation in terms of production and transportation costs.
 On a year-ago basis, both headline and core PCE inflation are above the implicit inflation target of the Fed of 1-1/2 to 2 percent inflation. As of June, the headline year-on-year pace stood at 4.1 percent while the core rate came in at 2.3 percent.
Looking ahead to the second half, consumers are likely to have reason to slow the gains in spending. The mailing of income tax rebate checks ended in mid-July and although it is clear that consumers did not spend the checks all at once, the vast majority of the stimulus impact is over. Also, labor markets remain weak with rising unemployment and a mild downtrend in payroll jobs. These factors will keep growth in wages and salaries sluggish in coming months. In turn, we can expect consumers to become increasingly cautious about spending and that points to sluggish economic growth ahead.
 With recent changes in the credit markets – including tighter lending standards and cut backs in credit card limits – and income tax rebate checks, there is a lot of noise in the monthly consumer credit numbers. But the recent trend appears to be for increased consumer reliance on credit. Consumer credit surged $14.3 billion in June for the largest monthly gain since November. Although the gain was centered in non-revolving credit, this was largely due to that component’s larger magnitude. Non-revolving credit rose $8.9 billion for the largest jump since August while revolving credit increased $5.5 billion. On an annualized percentage basis, nonrevolving credit increased at a 6.6 percent rate while revolving credit advanced 6.8 percent. Both were a little on the high side, especially when taking into account weak car sales in June and a cut back in available credit by some credit card lenders. The moderately strong June growth also is troubling when one remembers that income tax rebate checks were still showing up in mailboxes.
With auto sales weakening further, nonrevolving debt is likely to slow in July. But with little left of rebate checks and a softening labor market, the revolving credit portion may rise further. But credit card companies may clamp down further on credit card limts. Overall, with the end of rebate checks, slowing growth in wages and salaries, and tighter credit, the consumer likely will have fewer resources to fuel any rebound in economic growth during the second half.
The ISM non-manufacturing index improved in July to right at the break even mark, rising 1.3 points to 49.5. But the composite improved due to less weakness in employment and an unexplained increase in delivery time. Looking ahead,  U.S. purchasers reported declines in new orders, pointing to trouble for second-half growth and employment. The new orders index in ISM's non-manufacturing report fell nearly 1 point to 47.9, the lowest reading since January and the second lowest of the whole expansion.
The business activity index, the report's former headline index and equivalent to a production or shipments index, eased 3 tenths to 49.6 in July. Price pressures remained very high at 80.8.
 Productivity and labor costs in the second quarter were mixed but still point to cost cutting by companies and an easing in labor cost pressures. Second quarter productivity slowed to an annualized 2.2 percent increase, following a 2.6 percent gain in the first quarter. Unit labor costs continued to ease with a 1.3 percent annualized increase, following a 2.5 percent rise in the first quarter. The weaker gain in productivity was due to less of a drop in hours worked. Hours worked fell an annualized 0.5 percent, following a 1.6 percent drop in the first quarter. Output posted an annualized 1.7 percent advance after rising 0.9 percent in the prior quarter.
While quarterly numbers are a little volatile, the recent trend shows restrained growth in labor costs – largely due to cost cutting by companies. This is good news in terms of helping to ease inflation pressures. But the numbers also represent a softening in the labor markets and in consumer spending.
 At the August 5 FOMC meeting, there was considerable debate over the direction of monetary policy with sluggish economic growth and high inflation both being concerns. But with the recent flare up in the fragility of the credit markets, the Fed decided to keep anti-inflation moves on hold and kept its fed funds target rate unchanged at 2 percent. The FOMC statement indicates that the debate over when to focus on inflation may be picking up. The vote was 10 to 1 to keep the target the same with Dallas Fed President Richard W. Fisher voting to increase the rate at this meeting
Overall, the FOMC sees downside risks to growth and upside risks for high inflation as about balanced for now.
"Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth."
The Fed still sees inflation as high but expects inflation to moderate later this year and next.
"Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain."
The big question is why does the Fed see inflation coming down? There are two basic ways for inflation to come down from this point -- the economy is slowing enough on its own under current policy and/or the Fed tightens in the near future. Odds are that both will be the eventual reasons that inflation eases by 2010. The Fed may also get some help from less high oil prices -- due in part to slowing growth.
For now, the Fed still seems to be mostly concerned about the stability of the credit markets as Chairman Bernanke stated before Congress last month. The Fed still seems poised to raise rates to lower inflation -- but not until it is clear that credit markets have stabilized.
 Indeed, some FOMC members see current monetary policy as too loose – notably in terms of the real fed funds rate – the nominal fed funds rate minus the inflation rate. Of course, the real fed funds rate varies according to which inflation measure is used. Using headline PCE inflation on a year-ago basis, the real fed funds rates is about negative 2. Using core PCE inflation, the real fed funds rate is about a quarter percentage point negative. By either measure, real interest rates are quite low and should be stimulative. The counterargument is that financial markets are still fragile and lenders are less willing to lend at these low rates compared to the past.
 The markets have changed their views of pending changes in Fed policy dramatically over the last few months. In the middle of the Bear Stearns rescue in March, traders in the fed funds futures markets actually expected at least one more rate cut to get the fed funds rate to 1.5 percent by August. But improvement in the credit and equity markets, hawkish anti-inflation comments by Fed officials and a hawkish June 25 FOMC statement then led traders to expect a significant rate hike cycle to begin late this year with fed funds up to 3.5 percent by mid-2009. But the pendulum swung sharply in July with the reemergence of problems in credit markets, including a possible government bailout of Fannie Mae and Freddie Mac.
The bottom line is that the Fed is once again on hold until credit markets stabilize. That does not appear to be anytime soon.
The latest economic data show a very vulnerable consumer sector. While the latest easing in oil prices is in the right direction, gasoline prices are still highly elevated and are still constraining consumer spending. Labor markets are soft and income growth is slowing. The economy is likely to be very sluggish in the second half with consumer oriented businesses at risk – other than possibly discount stores.
This coming week we see a number of market moving indicators. On Tuesday, we see whether exports are still supporting the economy with the release of international trade data. Wednesday gives us a key look at the health of the consumer sector with the retail sales report. The latest consumer price numbers are reported on Thursday, and Friday’s industrial production report provides updated status on the manufacturing sector.
The U.S. international trade gap in May surprisingly narrowed despite a huge run up in oil prices as exports outpaced imports. The overall U.S. trade gap narrowed to $59.8 billion from $60.5 billion deficit in April. In May, exports continued upward with a healthy 0.9 percent gain while imports rose a moderate 0.3 percent. The oil gap actually shrank to $33.2 billion in May from $34.8 billion in the prior month, while the nonoil deficit widened to $38.0 billion from $35.8 billion in April. Not surprisingly, the average price of imported oil set another record high, reaching $106.21 per barrel in May from $96.81 per barrel in April. Looking ahead to June, we are likely to see another gain in exports and slowing in non-oil imports. Whether the overall gap worsens or improves will heavily depend on whether the physical volume (barrels) of oil imports dips and offsets at least one more monthly increase in the price of imported oil.
International trade balance Consensus Forecast for June 08: -$61.5 billion
Range: -$65.7 billion to -$59.0 billion
The U.S. Treasury monthly budget report showed a June surplus of $50.7 billion that was boosted by calendar quirks on government payments. The fiscal year-to-date tally tells the more meaningful story, at a deficit of $268.7 billion for a 122 percent increase from this time last year. Year-to-date, individual tax receipts are down 0.8 percent with corporate tax receipts down 15.4 percent. On the outlay side, defense spending is up 10.1 percent so far this fiscal year with social security and net interest payments showing mid single digit increases. Ahead, there's substantial risk that the nation's fiscal deficit will widen further as job contraction cuts back individual tax receipts which are the chief source of the government's income. This appears to be the case for July as the consensus expects a substantial widening in the deficit from prior July levels. The month of July typically shows a moderate deficit for the month. Over the past five years, the average deficit for the month of July has been $49.3 billion.
Treasury Statement Consensus Forecast for July 08: -$97.0 billion
Range: -$102.0 billion to -$59.0 billion.
Retail sales for June were disappointing with income tax rebate checks apparently going mostly into drivers' gasoline tanks. Overall retail sales posted a modest 0.1 percent in gain in June, following a 0.8 percent boost the month before. Excluding motor vehicles, retail sales increased a strong 0.8 percent in June, after advancing 1.2 percent the month before. However, strength was mostly due to higher gasoline prices. When excluding both motor vehicles and gasoline, sales advanced 0.2 percent, after rising 0.8 percent in May. More recently, unit new motor vehicle sales tanked in July and consumers are still reeling from high gasoline prices. Outside of gasoline station sales, the prognosis for retail sales is not good and even gasoline station sales could stall if drivers are staying off the roads more.
Retail sales Consensus Forecast for July 08: 0.0 percent
Range: -0.5 to +0.8 percent
Retail sales excluding motor vehicles Consensus Forecast for July 08: +0.5 percent
Range: +0.2 to +0.8 percent
Import prices spiked 2.6 percent in June – continuing a recent string of extremely sharp monthly increases and putting the year-on-year gain at up 20.5 percent. Import prices for petroleum surged another 7.4 percent in June while ex-petroleum import prices jumped 0.9 percent. A low dollar and high commodity prices clearly have led to a boost in imported inflation.
Import prices Consensus Forecast for July 08: +1.0 percent
Range: +0.5 to +2.0 percent
Business inventories are being kept in line by most businesses and are generally on the lean side with businesses expecting continued sluggish growth. Business inventories rose 0.3 percent in May, down from a 0.5 percent rise in April. The overall stock-to-sales ratio slipped to 1.24 from 1.25 in April and matched the record low set late last year. With the economy remaining soft, businesses will need to keep a tight rein on inventories.
Business inventories Consensus Forecast for June 08: +0.5 percent
Range: +0.4 to +0.8 percent
The consumer price index has been off to the races in recent months, boosted by higher energy costs. The headline CPI soared 1.1 percent in June, following a 0.6 percent surge the month before. The core rate firmed but not as dramatically with a 0.3 percent increase after a 0.2 percent rise in May. Once again, energy led the surge in overall inflation with a monthly 6.6 percent increase, following a 4.4 percent gain in May. Gasoline was up a monthly 10.1 percent after rising 5.7 percent in May. Food inflation accelerated sharply with a 0.8 percent jump in June, following 0.3 percent increase the month before. We may get some slowing in headline inflation as gasoline costs were rising less rapidly in July. But there still may be some pressure on the core number as still relatively high energy costs continue to filter into production costs.
CPI Consensus Forecast for July 08, m/m: +0.4 percent
Range: +0.2 to +0.6 percent
CPI Consensus Forecast for July 08, y/y: +5.2 percent
Range: +5.0 to +5.3 percent
CPI ex food & energy Consensus Forecast for July 08, m/m: +0.2 percent
Range: +0.1 to +0.3 percent
CPI ex food & energy Consensus Forecast for July 08, y/y: +2.4 percent
Range: +2.3 to +2.5 percent
Initial jobless claims continue to be boosted by the recent statutory emergency extension of unemployment benefits. Initial jobless claims for the week ending August 2 rose 7,000 to a much higher-than-expected level of 455,000 -- the highest level since the very beginning of the expansion in early 2002. The four-week average, at 419,500, is the highest since mid-year 2003.
Jobless Claims Consensus Forecast for 8/9/08: 440,000
Range: 420,000 to 465,000
The Empire State manufacturing index has been mixed on the production side in recent months but there is no doubt about the direction of prices – sharply up. The Empire State's general business conditions index posted a minus 4.9 reading in July indicating month-to-month contraction but was improved from the prior month’s minus 8.7. Readings for new orders and shipments were both solidly positive, coming in at 8.3 and 13.5. All three readings compare with negative levels in June. Price readings have been extremely elevated at a record 77.9 for prices paid, up from 66.3 in June, and at a record 32.6 for prices received, up from 26.7.
Empire State Manufacturing Survey Consensus Forecast for August 08: -2.8
Range: -10.0 to -1.0
Industrial production posted a strong gain in June but most of the strength was outside of manufacturing. Overall industrial production rebounded 0.5 percent following a 0.2 percent decline in May. However, the manufacturing component made a 0.2 percent comeback after slipping 0.1 percent in May. Utilities output increased 2.1 percent in June while mining output rose 1.1 percent. Manufacturing’s strength in June is not likely to repeat in July. Strength was led by a monthly 5.4 percent jump in motor vehicle output which followed a 0.6 percent rise in May. Excluding motor vehicles, manufacturing output slipped 0.1 percent -- the same as in the prior month. With the recent weakening in auto sales, we are likely to see manufacturing weaken despite ongoing support from exports. Overall capacity utilization in June rose to 79.9 percent from 79.6 percent in May.
Industrial production Consensus Forecast for July: 0.0 percent
Range: -0.3 to +0.2 percent
Capacity utilization Consensus Forecast for July 08: 79.8 percent
Range: 79.5 to 80.0 percent
The Reuter's/University of Michigan's Consumer sentiment index improved in July, coming off record lows. The Reuters/University of Michigan consumer sentiment index jumped to 61.2, nearly 5 points higher than the June reading. Both the current conditions and the expectations indexes improved. Likely reflecting a recent dip in gasoline prices, one-year inflation expectations dipped to 5.1 percent with 5-year expectations also down at 3.2 percent.
Consumer sentiment Consensus Forecast for preliminary August 08: 62.0
Range: 60.0 to 69.0
Econoday Senior Writer Mark Pender contributed to this article.
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