Equity prices are showing healthy gains from year-end levels. The Dow is up 5.2 percent, surpassing increases in the S&P 500 (+4.7 percent) and the Nasdaq composite (+4.6 percent). The small cap sector - which rebounded this week - is still outperforming the rest of the market with the Russell 2000 up 10.8 percent from year-end levels.

BONDS
Interest rates fell across the board this week as friendly inflation news had bond investors reassessing their views on future rate hikes by the Fed. For the most part, a rate hike announcement on March 28 is a given. But it remains to be seen what will happen at future meetings and at what fed funds rate target (4.75, 5.00 or 5.25 percent) the tightening will end. Of course, it depends on the economic data.

Not only did interest rates decline this week, but the shape of the yield curve has also changed. Yields at the long end are definitely higher than yields at the short end. But in contrast to last week, yields on 3-year and 5-year notes are now lower than 2-year note yields. The opposite was true last week.

Markets at a Glance

The Economy
TREND ANALYSIS IS USEFUL IN TIMES OF DATA VOLATILITY
Last month, some economic reports spiked up or down - due to unusual weather considerations. Most analysts and market players did expect either recovery or correction to these figures. But even knowing that the data were unusual, market players reacted to headline news with a short-term view. We look at three indicators here relative to their trend value to determine the extent to which current conditions are better or worse.

INDUSTRIAL PRODUCTION
The index of industrial production jumped 0.7 percent in February after declining 0.3 percent in January. The primary reason behind January's decline was that unseasonably warm weather reduced utilities production sharply - down 11.5 percent. One would have expected a rebound in February, but the 7.9 percent gain did not exactly offset the previous month's drop. Manufacturing production was unchanged in February after gaining 0.8 percent in January. The chart below compares the actual monthly changes in production to the three-month moving average of the monthly changes. The trend analysis suggests that activity was strengthening in the fourth quarter, but came down in February to the average pace we've seen through much of the past two years.

RETAIL SALES
Retail sales dropped 1.3 percent in February, reversing a portion of the 2.9 percent gain recorded in January due primarily to a 4.6 percent drop in auto sales. Excluding autos, retail sales fell 0.4 percent after surging 2.6 percent in January. While most of the components posted robust gains in January, most of the components recorded sharp declines in February. One certainly would get a better sense of retail spending by taking a longer-term view. The chart below compares monthly changes in nonauto retail sales to the three-month moving average of the changes. This picture is not unlike the trend in industrial production, although here the strength appeared to come in the third quarter rather than the fourth quarter. The most recent period appears to track with average levels seen through most of early 2005. Retail sales are neither weak nor robust, but appear on a solid track.

HOUSING STARTS
Housing starts dropped 7.9 percent in February to a 2.12 million unit rate after surging 15.8 percent in January to a 2.30 million unit rate. The January strength was initially surprising, but considering the unseasonably warm weather, and the typical problems with seasonal adjustment, the headline numbers were justified. The drop in February was also anticipated - although the consensus forecast called for a larger decline that would have brought starts nearly back to their December levels.

According to the Census Bureau, the agency that compiles these figures, it takes six months to establish a trend in housing starts. The chart below depicts actual monthly levels of housing starts compared with the six-month moving average of starts. Judging by the six-month trend line, housing starts reached a new peak in February. It appears that home construction was still going at a gangbuster pace this winter. We do have other housing data on hand, however, that point to a moderation in housing construction. For instance, new and existing home sales fell in January. (February figures will be out next week.) The MBA purchasing index has trended decidedly lower over the past three or four months. And the NAHB/Wells Fargo housing market index is also off of its highs. The March index level dipped again and the prospective buyer traffic is much lower than six months ago. Thus far, the data support a slowing trend in housing activity, not a plunge. But housing starts will begin to slow in the next few months.

Special factors, whether they are due to weather conditions or natural disasters, can play havoc with monthly economic data. At times like these, it is important to look at longer-term trends, rather than just headline numbers.

CPI SAYS INFLATION IS QUIESENT
The consumer price index inched up 0.1 percent in February after posting a 0.7 percent spurt in January. Energy prices fell 1.2 percent in February compared to a 5 percent hike in January, and food prices rose 0.1 percent versus 0.5 percent in the previous month. This helped dampen the overall CPI. Excluding these two volatile components, the core CPI increased 0.1 percent in February after rising 0.2 percent in January. Over the past 11 months, monthly increases in the core CPI have ranged from 0.0 to 0.2 percent. This is down from the previous 11 months where monthly gains ranged from 0.1 to 0.3 percent.

The chart below shows year-over-year changes in the major components of the CPI. The total CPI is 3.6 percent higher than a year ago, while the core CPI is 2.1 percent higher than last February. Transportation posts the largest yearly gain of 5.8 percent, but this includes gasoline prices, of course. Housing and medical care costs are both up 4 percent from year ago levels, but keep in mind that housing also includes fuels & utilities. Food & beverage prices, and "other" prices, are up 2.7 percent whereas education & communication prices are up 2.6 percent from a year ago. Recreation costs are up 1.1 percent and apparel down 1.8 percent.

Federal Reserve officials are usually less concerned about component prices than overall inflation. However, over the past couple of years, they have worried about the potential seepage of energy price hikes into the core CPI. For instance, how much will airfare costs rise because of higher jet fuel? And most industries are not immune to energy usage. So higher costs could come in any sector of the economy. Today, the core CPI is lower than it was a year ago when prices were up 2.4 percent. Granted, Fed officials would prefer to see inflation within a 1 to 2 percent range - and not at the high end of that range. These inflation figures are consistent with further Fed rate hikes, of course. But how many times the Fed will raise rates this year remains a question mark. A rate hike at the March meeting is in the bag. But the Fed officials weren't kidding when they repeated that future Fed rate hikes would be data dependent. Economists expect the fed funds rate to end up at 5 percent or 5.25 percent before the Fed is done, but this view could change with upcoming events.

THE CONSUMER PRICE INDEX - FROM A CONSUMER'S VIEW
As an economist, I hear the eternal complaint: "The rate of inflation is really faster than the government's measure." Frankly, the official CPI that we all know and love does not measure the actual inflation rate for any individual consumer. It is an average consumer basket. Does anyone fit that average? Not likely. For instance, if you are a teenager buying clothes and recreation goods, inflation isn't a problem! However, if you are a parent paying increasingly higher tuition costs (education was up 6.2 percent in February from a year ago), inflation is far worse than the official numbers appear. And we are all paying nearly 21 percent more on gasoline this year than last year. And yes I think we (consumers) should look at the total CPI, not just the so-called core rate that excludes the necessities of food and energy.

Even if we were to buy the same basket of goods as the "average" consumer, there is no question that the way the basket is measured can be misleading. For instance, the laptop you purchase today for $1,300 is far more powerful than the same laptop you purchased four years ago for the same price. However this same price would show up as a sharp drop in computer prices in the CPI. (My husband just bought a new Livestrong HP to replace his Toshiba and though we saw that the new price of the 2006 computer matched the price of the 2002 computer, it did not feel like a bargain even though the new computer is far more powerful than the old.) Yet, consumers must purchase more powerful computers to run the new software that won't work on old, less powerful ones.

What about comparing cable TV to high definition cable? Today, we are given the option to improve our reception with high definition versions of the same cable stations; of course these cost more. Are these truly higher prices, or are we paying for an improved product? (Even I have to admit that the HD gives a clearer picture.) Today, HDTV is still not the standard in everyone's household, but by 2008, these will be the industry standard by government regulation.

Thus far, I've given two types of problems with a personal CPI versus the average CPI. We have different purchasing needs or desires, and some products are adjusted for quality to show a lower price. There is another factor that plays a role in prices - and that is geography. Location, location, location! Prices for goods and services vary across the country, and depending on the local economy, they can rise faster or slower. My colleague on the East Coast continuously faces higher gasoline prices than I do in the Pacific Northwest. Yet, when I have visitors from the Midwest, they comment on the much higher food prices that we have here. While it is true that the Internet may have created an environment in which more prices (of tradable commodities) are equivalent across the country, there are still prices of goods and services that are not. The official CPI is the U.S. city average. Alas, most of us don't live in the average U.S. city.

The Bottom Line
Market players got a flavor of economic conditions with incoming February data that are offsetting much of the January changes. Seasonal adjustment is never perfect and unusual weather patterns can wreak havoc with statistical averages. On the whole, economic activity appears to be on trend with the pattern of the past year. Retail sales, industrial production and even housing starts are showing similar trends to what we saw in 2005. Inflation trends are not worsening either, but overall levels are still higher than those favored by Fed officials.

Housing starts turned out to be stronger than expected, but just about everyone is looking for a slowdown. New and existing home sales will be closely monitored by market players this upcoming week. Also, the plunge in January durable goods orders set the market on edge! All eyes will be on the upcoming February orders report. And while the consumer price index tends to be more popular than the producer price index, market players will be dissecting the PPI for potential inflation spikes down the road.

Looking Ahead: Week of March 20 to March 24

Monday
A few components of the index of leading indicators were negative in February: building permits, consumer expectations, the interest rate spread, vendor performance, and stock prices. In addition, new jobless claims were higher during the month and this counts as a negative factor. The factory workweek was up for the month. Information is still not available on new orders for consumer goods and capital goods.

Leading indicators Consensus Forecast for Feb 06: -0.3 percent
Range: -0.2 to -0.4 percent

Tuesday
The producer price index increased 0.3 percent in January as energy prices remained unchanged during the month. Excluding energy and food, the PPI rose 0.4 in January. Increases in the core PPI were generally moderate in the second half of 2005, but the year began with a spike.

PPI Consensus Forecast for Feb 06: -0.2 percent
Range: -0.9 to 0.2 percent

PPI ex food & energy Consensus Forecast for Feb 06: 0.1 percent
Range: 0.0 to 0.2 percent

Thursday
New jobless claims rose 5,000 in the week ended March 11 to 309,000, bringing the 4-week moving average up to 296,500. This was the second time in eight weeks in which claims pushed over the 300,000 mark and the third straight weekly rise.

Jobless Claims Consensus Forecast for 3/18/06: 306,000
Range: 300,000 to 315,000

Existing home sales declined 2.8 percent in January to a 6,560,000-unit rate. The MBA purchase index was down sharply in February over the January average suggesting more weakness during the month. Also, single-family housing starts fell moderately in February.

Existing home sales Consensus Forecast for Feb 06: 6.50 million-unit rate
Range: 6.40 to 6.75 million-unit rate

Friday
New orders for durable goods plunged 9.9 percent in January after increasing in the three previous months. The drop was primarily due to declining aircraft orders, but these have generally been up over the past year - and will be up again in 2006. Aside from aircraft, new orders have been sluggish.

Durable goods orders Consensus Forecast for Feb 06: 1.5 percent
Range: -0.7 to +3.5 percent

New single-family home sales decreased 5 percent in January to a 1,233,000-unit rate. The MBA purchase index was down in February over the January average and single family housing starts decreased modestly during the month.

New home sales Consensus Forecast for Feb 06: 1,200,000-unit rate
Range: 1,170,000 to 1,275,000-unit rate