Inflation: Above the Fed's Comfort Zone

The Aug. 15 reports show that the core Consumer Price Index is up slightly while the manufacturing sector continues to hum along

Amid the recent turmoil in the credit markets, economic data releases haven't received the full attention of many market watchers. But Wall Street got some important updates on consumer-level inflation and the factory sector Aug. 15, along with a reading from the New York Fed on manufacturing conditions in the region.

The reports showed that core consumer inflation, which excludes food and energy prices, remains stubbornly above the Federal Reserve's comfort zone. On the plus side, other releases showed solid factory sector readings for both July and August.

What About Interest Rates?

We still believe solid fundamentals suggest solid growth through the second half of the year, though credit concerns will override market interest in the economy over the near term. A still-tight labor market, rising wages for skilled workers, high rates of resource utilization, a weaker dollar, slowing productivity, and rising unit labor costs should keep upward pressure on prices.

Against that backdrop, the Fed will likely sit tight on interest rates at its next meeting in mid-September even as financial markets gyrate. Indeed, we don't expect the Fed to respond to current market difficulties with a rate cut, as it would do little to resolve the market’s liquidity problems. Of course, if policymakers were to react, we suspect they'd have to make aggressive cuts.

Here is Action Economics' rundown of the Aug. 15 releases:

Consumer Price Index

The CPI rose 0.1% in July, with the core index up 0.2%, versus June's gains of 0.2% for both. Energy prices fell another 1.0% after slipping 0.5% in June. Gasoline prices were down 1.7% after a 1.1% decline in June. Housing costs rose 0.2%, with the owners equivalent rent measure at 0.2%. Food prices were up another 0.3%. Apparel prices rebounded 0.4% after declines over the prior four months. Vehicle prices were up 0.3%.

The headline CPI year-over-year gain moderated to 2.4% in July from 2.7% in June, though this measure will surge to the 3.7% area by November, as last year's big commodity price freefall no longer figures into the calculation. The prior cyclical peak was the 4.7% reading after Hurricane Katrina. The core year-over-year pace was unchanged at 2.2% for the third consecutive month, which keeps this measure stubbornly above the Fed's 2% soft target.

Empire State Index

This regional manufacturing gauge fell only slightly, to 25.06 in August, versus the 26.46 reading in June. The employment index edged up to 11.62 from 11.39. New orders dipped to 22.21 from 26.52. Prices paid were flat at 34.41, while prices received dipped to 3.23 from 8.64. As for the six-month outlook, the general business conditions index improved to 50.40 from a revised 48.24.

The mix leaves the average adjusted reading for the major sentiment reports in August leaning toward the 56 averages of May and June rather than the 55 level of July, and well above the 51-53 readings in the first four months of 2007. This year's firm sentiment readings have reversed much of the 2006 downtrend from a 58 average early last year.

The inventory downdraft for GDP reversed direction in the second quarter, leaving a GDP bounce for the period that we now peg at 4.3%, vs. the 3.4% advance estimate, and a 2.8% clip for the third quarter. This stronger growth path for GDP over the two-quarter period is providing a solid floor for the factory sector, despite market turmoil.

Industrial Production

Industrial production rose 0.3% in July after a revised 0.6% increase in June. May's 0.1% decline was revised down to -0.2%, but April was boosted to 0.6% from 0.4%. The July gain boosted capacity utilization to 81.9%, from 81.8% (revised from 81.7%) in June. Manufacturing production was up 0.6%, with motor vehicle production climbed 2.6%. Utility production fell 2.1%, while mining edged up 0.7%.

The report, with revisions, was modestly stronger than expected, as the July gain was largely in line with the flat factory and mining hours-worked figures for the month alongside a 1.8% bounce in vehicle assemblies. Meanwhile, the boost to the April and June figures left a modestly stronger second-quarter trajectory for the index overall.

We now expect a 3% third-quarter growth clip for industrial production, following an upwardly revised 3.3% (from 2.9%) pace in the second.

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