Incidentally, the view that the Fed will have to tighten further to stop inflation in its tracks is leading to the view that economic activity will soften. As a consequence, it burst some of the exuberance of the oil and gold bubble. Gold prices dropped almost 8 percent this week and crude oil prices fell nearly 5 percent!

BONDS
Higher-than-expected inflation frightened the stock market, but if bond investors were truly frightened about inflation, we would have seen rapidly rising yields, particularly at the long end of the curve. In fact, yields dipped this week - in some cases, by a large margin. For instance, 30-year bond yields are down 16 basis points from a week ago and 10-year note yields are down 13 basis points. At the short end, the decline is much smaller - only 4 basis points on the 2-year note.

Bond investors do believe that the Fed will raise rates further, even though it doesn't seem like it at first glance. Bond investors are more inclined to believe that future Fed rate hikes will dampen economic activity. More and more economists are sounding the "slowdown" alarm. Rising interest rates will increase borrowing costs - and this will dampen consumer spending. Of course, consumer spending is already being hurt by high gas prices. And with mortgage rates rising and housing appreciation moderating, it means that the refinancing cash station will be slowing to a trickle.

Finally, whenever the stock market takes a tumble, investors must park their funds somewhere. Usually that leads to a demand for Treasury securities - and that reduces their yields.

Markets at a Glance

The Economy
CPI JUMPS
The consumer price index jumped 0.6 percent in April after posting a smaller 0.4 percent hike in March. Energy prices were primarily responsible for the spurt, rising 3.9 percent during the month. Food prices were unchanged. Excluding food and energy, the CPI rose 0.3 percent for the second straight month. Ever since energy prices began their upward climb, economists, market players and policymakers have worried that higher energy prices would seep into the core CPI. As it turns out, higher energy prices did not indirectly cause the core CPI to accelerate in March and April. Apparel costs, a component that usually posts declines, jumped in both March and April. But more importantly, rent costs accelerated - and the rental component of the CPI holds a significant weight.

Rent accounts for 5.8 percent of the CPI and owners' equivalent rent accounts for 23.4 percent of the CPI. While the Bureau of Labor Statistics does survey prices of rental units across the country, they don't have actual samples of "owners' equivalent rent" since it is imputed by using the prices for regular rental units. Owners' equivalent rent reflects what homeowners would pay for their home if they were renting instead of owning it. The way the Bureau of Labor Statistics measures rent for owner-occupied homes has always been controversial. Until 1983, they measured changes in interest rates and housing prices, but this was criticized. Since 1983, they have looked at rental homes and compare the various features of these homes to homes which are purchased and occupied by their owners. In reality, rental homes and owner-occupied homes have a lot of differences and trying to equate the two is difficult. This is why many economists believe that the measure is not accurately reflecting housing costs. BLS statisticians defend their methodology since they say that it measures the costs of living in the home. Economists outside the Bureau of Labor Statistics are on both sides of the issues; that is, some agree with this method, and some don't. But rather than complain about the method that is currently used, it is more useful to take it as a given and consider what it means for the current inflation status.

A few years ago, when mortgage rates were at 40 year lows, and before housing prices shot through the roof, many more people than today were able to afford to buy rather than rent. Today, it has become more expensive to buy a home, and rental vacancies have declined. Landlords have been able to raise their rents. Whether or not one approves of the BLS methodology of measuring housing costs for owner occupied units, one cannot deny that rental costs are truly rising both for renters and homeowners. Thus, it doesn't matter that the method is controversial, but it does matter that prices are increasing in CPI components other than energy.

That said, Fed officials are more inclined to focus on the core PCE deflator than the core CPI. The Bureau of Economic Analysis utilizes the underlying price data from the CPI for a good chunk of their index. The primary difference between the CPI and the PCE deflator is that the CPI is a fixed basket of goods and services while the PCE deflator is a variable basket. Moreover, the housing component has a slightly smaller weight in the PCE deflator than in the CPI. So rising housing costs may not appear as dramatic in the PCE deflator as in the CPI. However, this doesn't mean that the PCE deflator won't be scary too. These two series have moved in tandem over the past two years.

APRIL PPI SPURT
The CPI was not the only scary inflation number in the week. The producer price index jumped 0.9 percent in April after gaining 0.5 percent in March. The bulk of the hike was due to energy prices, which rose 4 percent in April. Food prices were up 0.1 percent. Excluding food and energy, the PPI increased 0.1 percent, matching the March gain. Indeed, April's core PPI gain was not quite as scary as the core CPI, but the PPI benefited from an 0.8 percent drop in car prices, a 0.4 percent decline in tobacco prices, and a 3.7 percent plunge in computer prices. Passenger car prices in the PPI were 3.4 percent lower than the previous April. Incidentally, this did not entirely pass through to the consumer price index where new vehicle prices were only 0.3 percent lower than last April.

Aside from the food and energy components, the CPI and the PPI don't always move in tandem. Typically, when prices are soft, the PPI tends to show a much slower rate of inflation than the CPI. Remember that the PPI is primarily goods-driven while the CPI is primarily driven by services. Notice that the core CPI is now headed higher, while the core PPI is headed lower. Eventually, lower goods prices will help to dampen the overall gain in the core CPI. However, prices of services tend to take longer to pick up steam, and these may still be rising. This is exactly what the Fed needs to monitor closely.

HOUSING STARTS HEAD LOWER
Housing starts dropped 7.4 percent in April to a 1,849,000-unit rate after declining 6.4 percent in March. In April, total housing starts were 11.1 percent lower than a year ago. Unseasonably warm weather in January boosted starts to an unsustainably high level. It is more realistic to consider the trend level of housing starts which shows a less dramatic peak in January, and a less dramatic decline in March and April. But rising mortgage rates, along with extraordinary house price appreciation that is keeping many new potential homeowners out of the market, are now having a dampening effect on housing activity. And while it is unlikely that the housing market is falling into a freefall, it is likely that some of the recent declines reflect a lower degree of speculation in the marketplace since speculators can no longer buy today and flip tomorrow.

The housing market may not fall apart entirely this year. But houses are likely to languish on the market. A bigger issue for consumers is the climb in interest rates. Homeowners are not going to be able to cash out equity as readily as before. Some economists are revising down their GDP forecasts for the year - and some are mentioning the dreaded "r" word - recession. CNBC bond market commentator Rick Santelli noted Friday that perhaps the inverted yield curve really did suggest recession. Remember, former Fed chairman Greenspan noted the conundrum of low long rates last year. Of course, the declining housing market doesn't by itself point to an impending recession. But the inability to easily tap into home equity and rising gasoline prices do point to less consumer spending.

INDUSTRIAL PRODUCTION ACCELERATES IN APRIL
Housing starts may have softened, but industrial production improved in April, rising 0.8 percent for the month after posting smaller gains in the two previous months. While production of consumer goods inched up only 0.1 percent in April, business equipment jumped 1.8 percent. By major industry group, production accelerated across the board! Manufacturing production grew 0.7 percent and now stands 5.5 percent higher than a year ago. Mining production expanded 0.9 percent but is 0.3 percent lower than last April. Utilities production also grew 0.9 percent in April, and stands 2.5 percent higher than last year. The growth in utilities is not uniform: electricity is up 4.7 percent from a year ago, but gas is down 7.5 percent from last April.

Production growth is clearly accelerating from the weaker period of last summer. While the aircraft sector has been performing strongly, new orders outside transportation have not done so well - at least until recently. Durable goods orders showed some decisive improvement in March. April orders will be out next week, and it will be interesting to see if a new upward trend is revealed.

Keep in mind that it is not unusual for sectors of the economy to pass the torch. Now that the residential housing market is slowing down, we may see investment spending pick up on the nonresidential front and in capital equipment as well.

The Bottom Line
Housing starts fell, but industrial production improved. Initially, the real side of the economy didn't appear to impact market players much since they were focused on inflation. The PPI spike was concentrated in energy and not quite as scary as April's CPI spurt. More worrisome for market players was the acceleration in the core CPI. It implies that the Fed will be more inclined to raise rates at the June FOMC meeting rather than take a brief pause. Many economists debated the merits of a pause even before seeing the April CPI spike, but most surely will agree that a rate hike will be necessary to ensure new Fed Chairman Ben Bernanke's credibility as an inflation fighter.

By the end of the week, market players were beginning to worry not only about inflation, but also about the possibility that economic growth would weaken significantly. While there are indeed several factors, such as slower housing activity, less home refinancing and higher gas prices, that could dampen consumer spending, it takes time for a true recession to develop. The Fed still has a shot at finagling a soft landing. But it may now be more difficult since they must also ensure their credibility as inflation fighters. The current state of the economy is - uncertain - and that worries market players most of all.

Looking Ahead: Week of May 22 to May 26

Wednesday
New orders for durable goods surged 6.5 percent in March. Along with the February gain, this helped offset the January plunge. As usual, aircraft orders, which have generally been up over the past year, are causing most of the monthly volatility. In March, most key sectors posted gains, not just aircraft.

Durable goods orders Consensus Forecast for Apr 06: -0.5 percent
Range: -4.0 to +3.0 percent

New single-family home sales surged 13.8 percent in March to a 1,213,000-unit rate after plunging 10.9 percent in February. The MBA purchase index rose slightly in April after declining in March. The NAHB-Wells Fargo housing market index has been on the decline - suggesting less housing activity lately.

New home sales Consensus Forecast for Apr 06: 1,150,000-unit rate
Range: 1,075,000 to 1,215,000-unit rate

Thursday
New jobless claims surged 42,000 in the week ended May 13 to 367,000, related to strike activity in Puerto Rico; according to officials this should unwind in the next week or so.

Jobless Claims Consensus Forecast for 5/20/06: 315,000
Range: 310,000 to 335,000

The Commerce Department's advance estimate showed that real GDP expanded at a healthy 4.8 percent rate in the first quarter of 2006 with strength in consumption expenditures and investment spending. Based on the recent international trade figures, most economists are looking for an upward revision to the first quarter figures.

Real GDP Consensus Forecast for Q1 06: 5.9 percent annual rate
Range: 5.2 to 6.2 percent annual rate

GDP deflator Consensus Forecast for Q1 06: 3.3 percent annual rate
Range: 3.3 to 3.5 percent annual rate

Existing home sales inched up 0.3 percent in March to a 6,920,000-unit rate, with gains in the Northeast and Midwest and declines in the South and West. The MBA purchase index was up in April over the March average, but the NAHB-Wells Fargo housing market index has been falling lately.

Existing home sales Consensus Forecast for Apr 06: 6.75 million-unit rate
Range: 6.65 to 6.95 million-unit rate

Friday
Personal income increased 0.5 percent in March. Look for a similar or slightly larger gain in March based on the employment situation. Personal consumption expenditures rose 0.6 percent in March boosted by spending on services. The retail sales report showed that consumption expenditures rose modestly in April.

Personal Income Consensus Forecast for Apr 06: 0.7 percent
Range: 0.5 to 1.0 percent

Personal Consumption Expenditures Consensus Forecast for Apr 06: 0.6 percent
Range: 0.5 to 0.8 percent

At the mid-May reading, the University of Michigan's consumer sentiment index dropped to 79 from a level of 87.4 in April. While labor market conditions remain healthy, consumers are surely feeling the pinch of higher gasoline prices.

Consumer sentiment Consensus Forecast for May 06: 79.0
Range: 77 to 82