BONDS
Interest rates rose significantly over the week except on the short end. At the first of the week, however, rates were soft following last Friday's soft jobs report. However, by Wednesday, doubts returned to the markets that the Fed's pause might not last. Rates edged up Wednesday and Thursday. Friday's robust retail sales numbers changed market psychology substantially, leading many to believe that the Fed's pause would not last.

Net for the week the yield curve was up significantly except on the 3-month bill. For the 2-year note through the 30-year bond, rates jumped from 6 to 11 basis points, basically returning to yield curve levels prior to the weak July jobs numbers. The 3-month bill slipped 1 basis point for the week net.

Markets at a Glance

The Economy
The Fed Pauses
On August 8, the Fed's Federal Open Market Committee voted to leave the federal funds target rate unchanged at 5-1/4 percent as expected by the markets. Apparently, the latest jobs report which came in with weak job gains tipped the balance toward pausing. However, several things stand out from the Fed's statement that followed the vote. First the vote was not unanimous. Richmond Fed President Jeffrey Lacker voted to raise the funds immediately by an additional 25 basis points. This dissenting vote, the first for an FOMC since September 2005, suggests that the vote for a pause probably was close in terms of the arguments for and against. Next, the statement clearly has a "bias" toward further tightening should incoming data or changes in the forecast indicate further interest rate increases are appropriate. The Fed acknowledged that inflation remains high with the core CPI year-on-year rate now up to 2.4 percent - well above the Fed's long-term target. The interesting omission in the statement was any reference to counting on productivity gains to constrain inflation. Earlier on the same day as the Fed policy vote, productivity numbers came out with a weakening in productivity growth combined with a spike in unit labor costs. Fed officials have made recent statements that productivity gains were being counted on to keep higher wage gains from being passed along in higher inflation. The Fed clearly is relying on its forecasts for the economy and inflation more than current numbers. This is a valid approach - given the long lags from changes in monetary policy to the impact on real growth and inflation.

Indeed, the Fed did admit that inflation has been on the high side. Comparing recent inflation numbers with fed funds suggests that the current stance of monetary policy is not quite as firm as during the 1999-2000 stance when inflation did come down. However, the economy also tipped into recession - the Fed missed making a soft landing.

However, when looking at the real fed funds rate, the current monetary stance is only modestly above neutral. In the recent past, real Fed funds have needed to be at least 4 percent to bring inflation down but are now only in the 3 percent vicinity.

And consumers keep on spending
Two notable economic reports from last week raised significant questions over the wisdom of the Fed pausing - the retail sales and productivity reports. Overall sales jumped 1.4 percent in July, following a 0.4 percent drop in June. The consumer sector had slowed in the second quarter and moderation is needed to get GDP on a sustainable path. Certainly second-quarter personal consumption was a little too slow and some firming in consumer spending was needed, but July's retail sales came in hot - even after discounting for price effects on gasoline sales. Retail sales data are key inputs into the durables and nondurables components of personal consumption expenditures in the GDP report. Excluding motor vehicles, retail sales jumped 1.0 percent in July, following a 0.1 percent increase rise in June. Taking out the volatile gas station and motor vehicles components, sales posted a solid 0.7 percent boost in July, following no change in June.

July's strength was widespread with sizeable gains in motor vehicles, gasoline station sales, and electronics. Increases were also seen in building materials, and clothing. Recent weekly indicators regarding retail sales showing some continuing softness were matched by the key weakness in July retail sales - department store sales.

With the rebound in retail sales, a key question is what would the Fed be counting on to lead to more moderate consumer spending? There are some Fed forecast details that are not public but are obvious choices - even though the magnitude of weakness clearly is uncertain. Housing is the one key part of the outlook upon which nearly every one agrees is softening. With this softening, there will be slowing or even declines in purchases of big ticket items such as refrigerators, air conditioners, stoves, washers, and driers. Additionally, consumers have counted on home equity lines of credit to boost spending and price appreciation has slowed dramatically. Wage growth is still strong but employment growth has slowed. So, the Fed's outlook for the consumer may prove to be correct despite last week's strong retail sales numbers. But on the other hand, the outlook "game" now is one of magnitude - the Fed could get the direction for consumer spending correct (slowing) but the slowing still may not be enough.

Productivity raises questions about inflation assumptions
Until last week's FOMC statement came out right after a generally adverse productivity report, Fed officials have repeated pointed to healthy productivity growth as constraining inflation. Productivity has been allowing wage gains without the inflation increases. However, last week's productivity report raised some doubts about that scenario.

To a large degree, the direction and rough magnitude of productivity is usually not a surprise, given that output numbers similar to GDP go into productivity calculations. And when output growth slows but labor input does not, then labor productivity goes down. That is what happened in the second quarter. Nonfarm productivity in the second quarter slowed to a 1.1 annualized percent rise from a revised 4.3 percent jump in the first quarter. This slowing was consistent with the slowing in GDP to 2.5 percent in the second quarter from 5.6 percent in the first quarter.

The Fed is counting on productivity gains to continue, but that is not going to happen with moderate GDP growth unless units of labor (workers and hours worked) post slower growth. That is not yet happening to the degree needed and unit labor costs have been rising. Unit labor costs jumped 4.2 percent annualized in the second quarter, following a 2.5 percent increase in the first quarter. Without cutting labor costs as revenue growth slows, businesses are not going to have the same profit cushion as in recent quarters. Notably the Fed has counted on a profit cushion to keep inflation pressures down and that cushion is deflating in the current environment of rising unit labor costs and a forecast for slower economic growth.

But with the jump in consumer inflation and economy-wide inflation due to energy and other factors, workers are feeling pinched also. Real compensation (inflation adjusted) only rose 0.4 percent annualized in the second quarter, following a 4.7 percent surge in the first quarter. This is not a pretty scenario for both labor and businesses to be squeezed at the same time.

Productivity gains have only just recently slowed. On a year-on-year basis, productivity slipped to 2.4 percent in the second quarter from 2.7 percent in the first quarter. However, unit labor costs have been on a strong uptrend for several quarters. Unit labor costs jumped to 3.2 percent year-on-year rate from 2.0 percent in the first quarter.

Non-oil import prices slow but still have momentum
Price indicators for all facets of the economy are getting closer scrutiny for signs of slowing in inflation. The foreign trade sector price indicators are no exception. In June, overall import prices jumped 0.9 percent, following no change in May and two large increases in April and May. June's boost was led by a 4.7 percent surge in petroleum import prices. Non-petroleum import prices actually slipped 0.1 percent but followed three consecutive gains. The bottom line is that import prices remain hot due to strong global demand for energy and other inputs.

The year-on-year inflation rate for non-petroleum import prices is 2.3 percent, compared to petroleum imports being up 29.6 percent. It is notable that the non-petroleum components diverge somewhat. On a year-on-year basis, the industrial supplies component is up 19.8 percent while foods, feeds & beverages component is up 3.9 percent. Both are clearly creating a profit squeeze for U.S. manufacturers and/or inflation pressures for the consumer. Import prices for capital goods, autos, and non-auto consumer goods have been the soft components, coming in at minus 0.4, plus 0.7, and no change, respectively. However, what is notable about these soft components is that they are not notably negative. The last time the Fed was raising interest rates to bring core inflation down, it had help with negative non-petroleum import prices overall.

Monthly international trade adds to economic growth
The U.S. trade gap narrowed in June to $64.8 billion, from revised $65.0 billion in May. The first key fact from this report was that exports continue to be strong, providing some backbone for continued economic growth. On the export side, merchandise gains were across the board. The second key point is that the deficit was narrower than assumed by the Commerce Department in its initial estimate for second quarter GDP. It now looks like real GDP for the second quarter is closer to 3 percent than to 2.5 percent.

Business inventories rise but is this a good sign or a bad sign?
Inventories can lead to sharp swings in production if any changes are unplanned. This could be an issue now. Business inventories rose 0.8 percent in June, following a 1.1 percent jump in May. Recent gains have been strongest at the retail level but still strong at the manufacturing and wholesale levels. Inventory-to-sales edged up to 1.26 in June from 1.25 in May but remained relatively lean. Last week's strong retail sales numbers for July do suggest that much of the inventory accumulation was in anticipation of strong demand. Nonetheless, inventories bear watching for any unintended accumulation.

The Bottom Line
The Fed is counting on its forecast for moderating economic growth to bring inflation down. We do not know the details of the forecasts and have to infer much from Fed officials' commentary. Clearly, the Fed's forecast for housing and related consumer spending on household durables plays a key role in slowing the economy and bringing inflation down. However, right out of the gate after the pause, the implied forecast for the consumer sector seems a little off track with consumer spending on the high side although lagged effects of earlier rate increases plus less push from home equity based spending could bring it into line. Higher unit labor cost figures, lower productivity, and high import prices also do not quite fit the Fed's inflation plan. The Fed's preferred path is a narrow one and we can expect incoming data to scatter on both sides of that path. But for now, incoming data point to the pause not lasting long. This week's PPI and CPI numbers for July will give additional food for thought in the debate over progress in the inflation fight.

Looking Ahead: Week of August 14 to August 18

Tuesday
The producer price index posted a large 0.5 percent increase in June, following a 0.2 percent increase in May. The core rate rose 0.2 percent in June, following a 0.3 percent rise in May. A disturbing upward trend has been seen in the year-on-year core rate which jumped to 1.9 percent from 1.5 percent in May. While we cannot really expect much relief yet on the overall PPI due to higher oil prices, the key issue is whether we will see softness in the core rate. We should see weakness in core PPI before we see deceleration in the goods portions of the core CPI.

PPI Consensus Forecast for July 06: +0.4 percent
Range: +0.1 to +0.6 percent

PPI ex food & energy Consensus Forecast for July 06: +0.2 percent
Range: +0.1 to +0.3 percent

The New York Fed's Empire State Manufacturing Survey index fell sharply in July to 15.6 from 29.0 in June. Weakness probably was related to flooding in the Northeast. We should get something of a bounce back in August. A key question is whether any rebound is back to June's pre-flooding levels or not.

Empire State Manufacturing Survey Consensus Forecast for August 06: 14.0
Range: 8.0 to 17.5

Wednesday
The consumer price index eased to a 0.2 percent in May, following a 0.4 percent spike in May. But the all-important core CPI posted its fourth consecutive 0.3 percent increase. The year-on-year core inflation rate is up to 2.6 percent compared to 2.4 percent in May. Core inflation needs to moderate down to 0.2 percent on a regular basis soon for the Fed's projections to hold true. And eventually we need to see some occasional 0.1 percent gain to reach a goal of core inflation at or below 2 percent annualized.

CPI Consensus Forecast for July 06: +0.4 percent
Range: +0.4 to +0.5 percent

CPI ex food & energy Consensus Forecast for July 06: +0.3 percent
Range: +0.2 to +0.4 percent

Housing starts slipped 5.3 percent in June following a 6.6 percent jump in May. June's starts were at an annualized pace of 1.850 million units from May's revised 1.953 million unit pace. There is much talk that housing inventories are on the high side. We may see this overhang reduce starts in July and even in later months.

Housing starts Consensus Forecast for July 06: 1.80 million-unit rate
Range: 1.78 million to 1.89 million-unit rate

The index of industrial production jumped 0.8 percent following a revised 0.1 percent increase in May. The manufacturing component also posted a hefty 0.7 percent in June. Industrial production has been running stronger than the regional manufacturing surveys. Recent leading indicators for industrial production have been a little mixed with business inventories up in June and durables backlogs rising. The inventory number could reflect either overhang or a planned build up in anticipation of strong demand. Recently strong unfilled factory orders and the strong July retail sales numbers suggest that factory demand is healthy, however. Hence, we should see a nice industrial production number for July.

Overall capacity utilization in June stood at 82.4 percent

Industrial production Consensus Forecast for July: +0.6 percent
Range: +0.3 to +0.7 percent

Capacity utilization Consensus Forecast for July 06: 82.7 percent
Range: 82.5 to 83.0 percent

Thursday
Jobless claims rose 7,000 in the August 5 week, following an increase of 7,000 for the July 29 week. Initial claims have been at a relatively low level for all of 2006. The 4-week moving average for the latest period was 308,750, a decrease of 3,750 from the previous week's revised average of 312,500. Excluding Katrina effects, the recent peak in initial claims was 456,000 for April 19, 2003. For the economy to be slowing we should be seeing more of a pick up in initial claims than in recent weeks.

Jobless Claims Consensus Forecast for 8/12/06: 315,000
Range: 310,000 to 320,000

The Conference Board's index of leading indicators rebounded 0.1 percent in June, following a 0.6 percent drop in May. This indicator remains below its recent peak this past January and is pointing toward a moderation in economic growth.

Leading indicators Consensus Forecast for July 06: +0.1 percent
Range: -0.1 to +0.2 percent

The general business conditions component of the Philadelphia Fed's business outlook survey index declined 6.0 in July from 13.1 in June and was likely impacted by flooding in the region, similar to the New York Fed's manufacturing index. Attention will likely be given to the price indexes since these indexes have picked up recently.

Philadelphia Fed survey Consensus Forecast for July 06: 8.0
Range: 3.6 to 10.0

Friday
The University of Michigan's consumer sentiment index slipped in July to 84.7 from 84.9 in June. Despite monthly volatility, confidence readings remain very moderate and low compared to 2004 and pre-Katrina 2005. The markets will be watching the overall reading to see if the consumer sector can walk the narrow path of moderate growth. Additionally, inflation expectations have edged down and this could have an impact down the road on whether the Fed's pause in rate hikes is temporary or not.

Consumer sentiment Consensus Forecast for August 06: 83.8
Range: 80.0 to 84.0