If oil prices level off, we will not see a strong impact on headline PPI and CPI numbers as oil components move from negative contributions to neutral on inflation numbers.

STOCKS
Stocks made notable and broad-based gains over the week. The Dow set four additional record closes before declining on Friday. On Monday, lower oil prices - fueled by speculation that OPEC could not maintain production cuts - boosted stocks, especially the large caps and companies that depend on consumer discretionary income (such as Wal-Mart and the Gap). On Tuesday, there were notable upside surprises on earnings - GM, American Express, and Amazon.com among others. Wednesday, stocks posted modest gains on the news that the Fed was not raising rates nor raising its level of concern over inflation compared to the prior FOMC statement. Higher oil prices stemmed the gains. Also, weak third quarter results from Boeing and GM kept index advances modest. On Thursday, techs joined the party and boosted the Nasdaq sharply. Friday, the weak GDP report raised concerns about a softening in revenues, causing most major indexes to decline.

For the week, all major indexes were up, net: the Dow, up 0.7 percent; the S&P 500, up 0.6 percent; the Nasdaq, up 0.4 percent; and the Russell 2000, up 0.5 percent. Year-to-date, the Dow is up 12.8 percent; the S&P 500 up 10.3 percent; the Nasdaq up 6.6 percent; and the Russell 2000 up 13.8 percent.

BONDS
Interest rates ended the week sharply lower in relief to no further signs of tightening from the Fed and from weaker-than expected GDP growth for the third quarter. However, rates were headed in the opposite direction on Monday as talk at that time was that the Fed's revised internal forecasts suggested that earlier forecasts for inflation were too optimistic. Tuesday, traders sat on the sidelines waiting on the Fed, and rates were little changed. Rates slipped Wednesday on the Fed showing no further signs of tightening for now and also on weak existing home sales data - including a decline in the median sales price. Rates continued to fall Thursday after markets figured out that the durables orders report was actually sluggish once aircraft orders were discounted. On Friday, the very soft GDP report pushed rates down even further.

Net for the week the Treasury yield curve is down sharply except on the front end. Notes and bond yields fell as follows; 2-year Treasury note, down 12 basis points; 3-year, down 12 basis points; 5-year, down 13 basis points; 10-year bond, down 12 basis points; and the 30-year bond, down 11 basis points. The 3-month Treasury bill edged up 2 basis points.

Long-term rates took a notable dip last week, reflecting weaker current economic growth and the expectation that the Fed will be cutting interest rates next year. The 3-month T-bill remained anchored to the unchanged fed funds rate.

Markets at a Glance

The Economy
Last week the economic data were a little bumpy but as a whole they pointed to a continuation of a soft landing.

GDP on the low side but not as weak as believed
The Fed has been wanting economic growth to be below potential for a few quarters to bring inflation down, and last week's GDP report helped on that front. Third quarter real GDP decelerated sharply with an annualized increase of 1.6 percent, following 2.6 percent in the second quarter and 5.6 percent in the first quarter. The markets had expected a 2.0 percent rise in GDP for the third quarter.

There really were no major surprises in the report - just an accumulation of components that came in somewhat below expectations. Where were the misses? These probably were in the components that were responsible for most of the deceleration in GDP. Imports were notably higher and residential investment declined at a faster pace than in the second quarter - likely more than most anticipated. Also, inventory growth slowed.

While there were some misses on the low side, we did see some strengthening in durables PCEs, investment in equipment & software, and in federal government spending.

Much as expected, overall strength for the quarter was led by a 14.0 percent boost in nonresidential structures investment, an 8.4 percent increase in durables PCEs, a 6.5 percent rise in exports, and a 6.4 percent gain in investment in equipment & software. Weakness was led by a 17.4 percent drop in residential investment and a 7.8 percent jump in imports.

Turning to inflation, the overall GDP deflator dropped to a 1.8 percent annualized pace in the third quarter from 3.3 percent in the prior four quarters. The latest slowing partly reflects lower energy costs. The consensus had expected the overall GDP deflator to post a 2.0 percent increase in the third quarter. The core deflator for PCEs - the preferred inflation measure of the Fed - also slowed somewhat to a 2.3 percent annualized pace from 2.7 percent in the second quarter.

Last week's GDP report was a boon to the bond market with participants believing that the economy was weaker than believed leading up to the report. But the economy may be in a little better shape than the 1.6 percent figure. Demand is healthier than production currently. Final sales to domestic purchasers actually rebounded to 2.2 percent from 1.6 percent in the second quarter. Final sales to domestic producers came in at 1.7 percent, however, in the third quarter. The difference between the two measures is the discounting of both inventory investment and net exports in the first and only inventory investment in the latter. If only the inventory figure levels off, then demand is still being siphoned off by growing net exports and we only get a mild bump up in GDP. If net exports level off or even deteriorate slower, we will get a little bounce in GDP - assuming domestic demand holds up. If housing is near its bottom, then that will become an additional factor nudging GDP back towards potential and slowing down the reduction in inflation.

Year-on-year, real GDP has eased to 2.9 percent in the third quarter from 3.5 percent in the second quarter. Year-on-year, the GDP deflator has edged down to 2.9 percent in the third quarter from 3.3 percent in the second quarter. On the same basis, the core PCE deflator growth rate came in at 2.4 percent in the third quarter, compared to 2.2 percent in the second quarter.

Housing remains soft but there are signs of the market fixing itself
Existing and new home sales moved in opposite directions in September but remained at lower levels. Importantly, builders and sellers moved to bring supply in line with demand by holding off on additional supply.

Existing home sales slipped 1.9 percent in September to a 6.18 million rate compared a 6.30 million rate in August. Sales are down 14.2 percent on a year-on-year basis, compared to 12.6 percent in August. Even as sales slipped, so did the supply of unsold homes as supply ratios held steady at 7.3 months for a third straight month.

In contrast to the continued decline in existing home sales, new home sales rebounded in September, rising 5.3 percent to a 1.075 million annual rate. Supply actually fell for new homes to 6.4 months supply in September from 6.8 months in August and 7.2 in July.

The sluggish housing market now appears to be having a secondary effect that has been expected by the Fed. The Fed has been projecting a damping of consumer spending through less availability of home equity. We are now seeing signs of home values slipping as measured by median sales prices. Although there are signs of improvement, the continued weight of supply has nudged home prices down. The median price for an existing home slipped 1.8 percent in the month to $220,000 for a year-on-year decline of 2.2 percent.

For new homes, the median price fell 9.3 percent in September and, at $217,000, is the lowest in two years. September's median sales price for new homes is down 9.7 percent from September last year -- the largest year-on-year drop in nearly 36 years. At a minimum, these prices will be cutting into appraisal values upon which lenders depend for making new home equity loans.

Durables orders point to softening in manufacturing despite big headline number
Last week, the headline advance number for durable goods orders initially got the bond markets wound up over a too strong economy, but concern quickly eased in that the strength was almost all in Boeing aircraft orders. Durable goods orders rebounded a sharp 7.8 percent in September, following a revised 0.1 percent drop in August.

But the gain was mostly civilian aircraft orders which jumped a whopping 292.4 percent on a monthly basis in September, following a 30.1 percent drop in August. This reflected a bunching of orders for Boeing aircraft. Excluding nondefense aircraft, new orders actually fell 1.1 percent, following a 0.5 percent boost in August. Most of this weakness was in motor vehicles, however. Motor vehicles orders fell 6.1 percent in September after a 3.9 percent boost in August.

Even though strength (aircraft) and weakness (motor vehicles) was in transportation, after discounting both the overall picture is one of a slowing manufacturing sector. Excluding transportation, new orders edged up only 0.1 percent in September, following a 1.5 percent drop the month before.

But there were pockets of strength as well as weakness. Industry categories posting gains in September were machinery, electrical equipment, and transportation. Industry categories showing declines in September were primary metals, fabricated metal products, and computers & electronics. The "other durables" category was flat.

Overall, manufacturing is slowing somewhat but with forward momentum still seen in unfilled orders. Unfilled durables orders rose to a 21.8 percent year-on-year increase in August from 18.5 percent in August. Excluding transportation, however, unfilled orders have eased a little, slipping to a 13.0 percent year-on-year pace in September from 13.8 percent in August.

Indeed, manufacturing is decelerating with strength mainly in aircraft. At this point in the business cycle, we have to be careful to watch for cancellation of orders. There are no major signs of that but the "apparent" forward momentum of current unfilled orders could slip quickly if orders are cancelled. But with current demand for exports and domestic orders for capital equipment, that currently is not on the horizon.

The Fed holds steady
The Fed left unchanged the federal funds target rate at 5-1/4 percent as expected. The key outcome of the meeting is that the language of the statement was little changed from the prior meeting and the statement retained its anti-inflation bias. The markets took comfort in the fact that there was no "worsening" in the language of the anti-inflation bias. Even though recent economic numbers have fallen in line with the soft landing scenario, there still remains significant concern that interest rate hikes are not over. As with the September 20 and the August 8 FOMC meeting, the vote was not unanimous. Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, once again voted for an immediate increase of 25 basis points in the federal funds rate target, leaving the vote at 10 to 1 for no change. Clearly the Fed is still relying on its forecast for slowing economic growth to bring inflation down. But more Fed officials have been noting that there is higher risk that inflation will not come down enough given the current projections for economic growth. As before, the Fed in its wisdom stated than additional policy moves will be data dependent and actual inflation numbers will probably get greater weight than other data.

The bottom line
More sectors are showing signs of slowing as manufacturing is shifting from a source of strength to one that is in line with growth somewhat below potential. Housing's weakness continues but there are indications that it may be leveling off soon. Many of the components for the soft landing are in place - but not all. Import prices are still on the high side as are wages. However, the missing pieces are generally the lagging indicators in the economy - especially wage inflation and even the core inflation measures. Most likely, the recent data will not yet result in the Fed removing its anti-inflation bias in the next FOMC statement but may include a partial step toward that - the inclusion of a statement noting evenly balanced risks between unacceptably high inflation and possibly too weak economic growth.

Following last week's GDP release, the fed funds futures market lowered the implied fed funds rates such that there are now better than 50 percent odds for a 25 percent basis point cut by the May 2007 FOMC meeting. The implied fed funds futures rate is essentially a weighted average of the rates that the participants believe will exist for a given settle date. Simplistically, an implied rate that is halfway between two possible Fed targets (such as between 5 and 5-1/4 percent) implies equal odds for no change or a cut to 5 percent.

Looking Ahead: Week of October 31 to November 3

Monday
Personal income was up 0.3 percent in August, following a 0.5 percent jump in July. This report for September will contribute much to whether the economy is still on a soft landing and whether the Fed will lower interest rates anytime soon. It is a tricky balancing act for personal income to remain moderate and not slow too much. For the last report, the key wages and salaries component slowed sharply to a 0.1 percent increase in August. It actually might be good for the wages and salaries component to nudge up just a bit. However, average weekly earnings were soft in September and will likely translate to a very sluggish number for wages and salaries.

Personal consumption for August rose only 0.1 percent, following a 0.8 gain in July. More recently, retail sales fell 0.4 percent in September, based on weakness in autos and gasoline sales. So, we are likely to see a soft figure for durables outside of motor vehicles and nondurables within personal consumptions expenditures. Based on manufacturers sales numbers (a source not fully included in retail sales numbers), motor vehicles sales for September were up somewhat and should boost durables since these data do go into the personal consumption numbers.

With the latest FOMC meeting still on everyone's mind, a key focus of this report will be the core PCE deflator - the Fed's favorite inflation indicator. While we already have the quarterly figure from the GDP report, the personal income report will tell us how the core PCE deflator is on the margin. Both the overall PCE deflator and core PCE deflator rose 0.2 percent in August, following a 0.3 percent increase in July. The core PCE deflator, however, rose 0.2 percent in August, compared to 0.1 percent in July. On a year-on-year basis, the core deflator is up 2.5 percent, 0.2 percentage points higher from 2.3 percent in July.

Personal income Consensus Forecast for September 06: +0.3 percent
Range: +0.3 to +0.5 percent

Personal consumption expenditures Consensus Forecast for September 06: +0.2 percent
Range: -0.1 to +0.4 percent

Core PCE deflator Consensus Forecast for September 06: +0.2 percent
Range: +0.2 to +0.2 percent

Tuesday
The employment cost index rose a quarterly (not annualized) 0.9 percent in the second quarter, up from the first quarter's 0.6 percent rise. While this series does not get as much attention as the productivity and unit labor cost figures, it still is pointing in the wrong direction for the Fed to remove its anti-inflation bias. The average hourly earnings data from the employment situation report have been mixed over the last few months and do not yet suggest a slowing in the quarterly employment cost index.

Employment cost index Consensus Forecast for Q3 06: 0.9 percent simple quarterly rate
Range: 0.8 to 1.2 percent simple quarterly rate

The NAPM Chicago purchasing managers' index jumped to 62.1 in September. This index generally has been stronger than other regional manufacturing surveys.

NAPM-Chicago Consensus Forecast for October 06: 58.0
Range: 56.0 to 60.0

The Conference Board's consumer confidence index rose to 104.5 in September from 100.2 in August, likely as a result of lower gasoline prices. Oil prices have since fallen further, net, and the stock market has picked up new upward momentum. How much of these factors will show up in consumer confidence keeping the economy on a moderate growth path? Also, will lower gasoline prices lower inflation expectations? In the September report, the 12-month inflation expectations fell 6 tenths to 4.9 percent. The Fed continues to place importance on not losing control over inflation expectations.

Consumer confidence Consensus Forecast for October 06: 108.0
Range: 104.5 to 110.0

Wednesday
The Institute for Supply Management's manufacturing index slipped to 52.9 in September from 54.5 in August and is barely in the positive growth range. With the most recent softness in durables orders (after discounting aircraft orders) and in industrial production at the national level, markets will be looking at this first indicator for U.S. manufacturing to see if this sector is holding up well enough to keep the soft landing from becoming a hard landing.

ISM manufacturing index Consensus Forecast for October 06: 52.5
Range: 51.4 to 55.0

Construction spending rebounded 0.3 percent in August, following a 1.0 percent drop in July. Based on the recent upward nudge in housing starts in September, we may see a firming - albeit temporary - in residential outlays. Even if residential outlays edge up, that will be discounted. The key question may be how much will nonresidential outlays be offsetting the downtrend in residential outlays.

Construction spending Consensus Forecast for September 06: -0.3 percent
Range: -0.6 to +0.7 percent

Motor vehicle sales in September rose to an annual rate of 12.9 million from 12.3 in August. Will light trucks continue to pick up share now that gasoline prices have come down somewhat?

Motor vehicle sales Consensus Forecast for October 06: 12.5 million-unit rate
Range: 12.3 to 13.1 million-unit rate

Thursday
Initial jobless claims edged back up in the October 21 week, rising 8,000 to 308,000. Based on declines in prior weeks, however, the four-week average fell 2,750 to 305,250. Thus far, the labor market is not showing any substantial or sustained slowing from the Fed's tightening. Initial jobless claims generally are a leading indicator and thus far we are not seeing much leading sign of slowing in the economy.

Jobless Claims Consensus Forecast for 10/28/06: 310,000
Range: 300,000 to 315,000

Nonfarm productivity in the second quarter slowed to 1.6 percent from 4.3 percent in the first quarter. Unit labor costs in the second quarter remained very strong at a 4.9 percent annualized increase even though it was notably down from the 9.0 percent annualized spike in the first quarter. These kinds of numbers cannot continue without putting a squeeze on profits.

Nonfarm Productivity Consensus Forecast for initial Q3 06: 1.0 percent
Range: 0.0 to 1.5 percent

Unit Labor Costs Consensus Forecast for initial Q3 06: 3.4 percent rate
Range: 2.1 to 4.0 percent rate

Factory orders were unchanged in August, following a 1.0 percent drop in July. For September, we already have the advance numbers for durables orders which posted a huge 7.8 percent jump based on a surge in aircraft orders. So we should see a large overall figure since durables make up the lion's share of total orders.

Factory orders Consensus Forecast for September 06: +3.5 percent
Range: +2.1 to +6.2 percent

Friday
Nonfarm payroll employment slowed sharply in September in an anemic 51,000 gain in jobs. However, this followed moderately healthy increases in August and July with gains of 188,000 and 123,000, respectively. Is the labor market finally slowing or was September an aberration? After all, the unemployment rate actually fell to 4.6 percent from 4.7 percent in August as household employment has consistently been outpacing payroll employment gains for some time now. Average hourly earnings have shown signs of moderation with two months of 0.2 percent increases in August and September.

Nonfarm payrolls Consensus Forecast for October 06: +130,000
Range: +75,000 to +180,000

Unemployment rate Consensus Forecast for October 06: 4.6 percent
Range: 4.5 to 4.7 percent

Average workweek Consensus Forecast for October 06: 33.8 hours
Range: 33.8 to 33.9 hours

Average hourly earnings Consensus Forecast for October 06: +0.3 percent
Range: +0.2 to +0.4 percent

The business activity index from the ISM non-manufacturing survey slowed significantly in September but remained in positive territory. The index fell from 57.0 in August to 52.9 in September. However, new orders picked up in September - will new orders translate into stronger overall activity in October?

Business activity index Consensus Forecast for October 06: 55.0
Range: 52.4 to 56.0