The week's economic reports

Disappointing retail sales, rising consumer prices, plunging industrial production, and only modest net foreign capital inflows highlighted the week's economic data.

Stocks and bonds ended with the S&P 500 Index up 0.3 percent to 1,459, now up just 2.9 percent for the year, and the yield of the 10-year U.S. Treasury note fell 8 basis points to 4.15 percent.

Pending Home Sales: The National Association of Realtors reported a 0.2 percent increase for pending home sales in September following a sharp 6.5 percent decline in August. On a year-over-year basis, the index is down 20.5 percent. A modest increase in sales is predicted for next year, however, with inventory still near all-time highs the story in 2008 is likely to be sales prices and not sales volume.

Retail Sales: Retail sales rose 0.2 percent in October following an upwardly revised 0.7 percent gain in September. The increase was almost entirely driven by higher energy and food prices, sales at gas stations rising 0.8 percent and grocery store sales increasing by 0.6 percent. On a year-over-year basis, retail sales have risen 5.2 percent, also largely due to higher energy and food prices. Since retail sales are not adjusted for inflation, real annual gains at retailers have been about flat since the end of 2006.

While sales at building material and garden supply dealers rebounded 0.6 percent in October after declining during five of the last eight months, sales of furniture and home furnishings continue to be impacted by the housing market slowdown, falling 0.9 percent, the fourth decline in the last five months.

While this report is very misleading due to higher energy prices, it still does not show clear signs of the long-awaited major retrenchment in consumer spending predicted by many, though there is clearly a broad slowing trend since mid-2006. The impact of higher prices at the pump on holiday shopping is the subject of much debate at the moment - never before have gasoline prices been this high at this time of year and, when combined with extreme seasonal adjustments to the retail sales data in the months ahead, some very disappointing retail sales reports may be in store.

Consumer Prices: Consumer prices as reported by the Bureau of Labor Statistics rose at a seasonally adjusted rate of 0.3 percent in October, matching the September increase, due largely to higher energy prices. The year-over-year rate of inflation climbed to 3.5 percent, a level not seen since August of last year just prior to the sell-off in energy commodities that led to plunging year-over-year changes in the CPI as shown below.


Energy prices rose 1.4 percent in October and now show a 14.5 percent increase from year ago levels. Energy commodities have risen 22.5 percent over the last twelve months. Medical care costs rose 0.6 percent last month, up 4.8 percent year-over-year, and the price of food rose 0.3 percent in October, up 4.4 percent from a year ago.

Housing, which contributes 43 percent to the overall CPI rose just 0.2 percent, up 3.1 percent year-over-year, as rent increased 0.5 percent and owners' equivalent rent rose 0.2 percent. Rent and owners' equivalent rent account for 6 percent and 24 percent of the CPI, respectively.

As mentioned here before, part of the reason why the year-over-year inflation rate has been moving higher in recent months is that negative numbers have been rolling out of the 12-month calculation. Next month a 0.0 percent monthly increase from November of 2006 will roll out.

Also in next month's report, the full impact of higher energy costs should show up at the consumer level and distortions due to seasonal adjustments (based on much lower fuel prices typical of this time of year) will be an important factor likely to push the annual inflation rate over four percent.

Some analysts are now predicting that the overall CPI will show an annual gain of up to 5 percent in the months ahead. The Wall Street Journal Economics blog had a story on this a week ago (see chart) and several other more recent reports have echoed this view.

The CPI has not increased at an annual rate of five percent since 1991!

NY and Philadelphia Manufacturing Surveys: Growth in both New York and Philadelphia area manufacturing activity came in above expectations in November following a string of relatively weak readings over the last six months. These are very volatile indexes and are far less important than the broader ISM manufacturing index released two weeks ago that showed barely perceptible growth in manufacturing.

Treasury International Capital (TIC) Flows: The Treasury Department reported that net foreign purchases of long-term U.S. securities resulted in an inflow of $26.4 billion in September following the surprising outflow of $70.6 billion in August after the initial credit market turmoil caused by problems in subprime lending. Recall that the TIC data is watched closely because it is a rough measure of how easily the U.S. trade deficit is being financed by our international trading partners.

The monthly U.S. trade gap of between $50 and $70 billion requires similar capital inflows to square the books and the -$44.2 billion total of the last two months is a continuing cause for concern that foreigners may be growing tired of financing our trade deficit.

Industrial Production: Industrial production plunged 0.5 percent in October, the largest drop since January, indicating more trouble may be in store for the utilities, auto, and housing industries. Capacity utilization also posted a surprising decline, down to 81.7 percent from levels above 82.0 percent for the last three months. This report adds to the increasing view that a significant slowdown for the U.S. economy may now be underway.

Summary: Weak retail sales and declines in manufacturing mid-way through the fourth quarter add to the growing consensus of an economic slowdown as the year draws to a close. Rising consumer prices will persist for at least another month (possibly longer if energy prices continue to rise), making the job of the Federal Reserve even more difficult in the months ahead when deciding what to do with interest rates.

The Fed will be hard pressed to lower short-term rates from their current 4.5 percent level when annual inflation is running at about that same level as some are predicting will be the case in December - that would be a real Fed funds rate of close to zero, something that former Fed chief Alan Greenspan was much criticized for between 2002 and 2004. That level for the real Fed funds rate is reserved for an economy that is clearly distressed, an adjective that can not be properly applied to the current state of affairs.

The apparent waning interest by foreigners to fund the U.S. trade deficit adds to the overall uncertainty as the dollar has already declined sharply against other currencies and more rate cuts from the Fed will only serve to exacerbate this condition. Things are really getting interesting now and, unfortunately for the Fed, they are likely to get much more interesting in the months ahead.

The Week Ahead: The holiday-shortened week ahead will be highlighted by a report on housing starts on Tuesday. Also scheduled for release are the NAHB housing market index on Monday, the October Fed meeting minutes on Tuesday, and both consumer sentiment and leading economic indicators on Wednesday.