No one doubts the economy is slowing, but there is mounting debate as to how fast; will we get the “soft landing” that is hoped for or something more disruptive? Just a month or two ago the worry was that continued economic growth combined with tight labor might spark inflation. So far that has not happened. The most recent report of prices paid at the producer level released Tuesday showed a drop of .4%, well below expectations.

Everybody’s on hold; from the Space Shuttle Atlantis, to the Federal Reserve. While NASA hopes to launch today at 11:40 after a three year hold, we hope it will take considerably less time to re-launch the economy. The Fed has decided to hold further rate increases until it gets a better picture of the economy’s health. The Bank of Japan, the Bank of England and the Bank of Korea announced a similar strategy this week. Even OPEC is expected to hold oil production steady when they meet next week to see what happens. Doing so would help avoid a supply-driven run-up in prices. So the world watches the economic data to learn just how fast the US and the global economies are slowing.

Three weeks after the Federal Reserve ceased its 17th straight quarter point interest rate hikes debate continues as to whether they are finished, even among Fed officials. Minutes released from their latest meeting reveal that members expect core inflation “to decline gradually” and that pausing was a “close call.” Many believe that more increases may well be needed even while saying “the full effect of previous increases in interest rates on [economic] activity and prices probably had not yet been felt, and a pause was viewed as appropriate to limit the risks of tightening too much.”

Back in mid July we suggested the Fed might pause at its August meeting. On August 8th they held their benchmark lending rate at 5.25%, while saying that consumer prices will “moderate over time” because of their 17 prior rate increases, surging energy prices and a cooling housing market. In the eyes of many the move was a bold one for new Fed chief Ben Bernanke. Inflation hawks (those who believe inflation is worse evil than slow economy) immediately criticized his decision as a gamble that could jeopardize the Fed’s credibility as an inflation fighter. Yet, as the data have come in, the decision seems all the wiser. Both the Producer Price Index and the Consumer Price Index showed that inflation unexpectedly dropped last month. Housing starts slid 2.5% last month for the fifth time in six months. And yesterday, Conference Board said its index of leading economic indicators dropped in July.

Growth of the U.S.economy was less than half that of the first quarter, according to the Commerce Department in its first estimate of second-quarter Gross Domestic Product.  GDP increased at a seasonally adjusted 2.5% annual rate April, compared to 5.6% in the first quarter and also well below economists’ estimates of 3.2%. 

“Economic moderation seems to be underway” which “should help to limit inflation pressures over time” said Fed Chairman Ben Bernanke in his prepared comments to the Senate Banking Committee on Wednesday.  He noted the importance of “forward-looking” and taking a “longer-term” view as rate increases take time to affect the economy.  It may be that Mr. Bernanke and his Fed may have raised rates as far as they are going to for the foreseeable future. 

The Federal Reserve raised their benchmark interest rate for the 17th consecutive time yesterday which was a surprise to no one.  But in a surprise to many, they suggested for the first time that a pause might be coming soon.  Their statement said “the extent and timing of any additional” rate increases “will depend on the evolution of the outlook for both inflation and economic growth.” Stock markets surged on the news.  The Dow Jones Industrial Average soared to close 217.24 points higher than when the statement was released, a gain of about 2% - its best day in more than three years. The NASDAQ Stock Market was up 3%, its biggest one-day rally since March 2004. Long-term bond yields edged down as prices rose.

The Federal Reserve has increased rates by a quarter of a percent 16 times including their May increase without a major market drop, but one would think that the likely quarter point increase at the end of this month will be the straw that breaks the veritable camel’s (err bull’s) back.  Since that May 10th meeting the Federal Open Market Committee has become a ‘federal open mouth committee, as termed by one of our favorite economists, Ed Yardeni.  The mixed signals have rattled markets of all stripes, from stocks, to bonds, to commodities. 

May was very unkind to investors.  The S&P 500 declined 3.1% making it the worst monthly decline since 2004.  The Dow Jones 30 fared a little better, declining by 1.6%.  The NASDAQ has been on its longest decline since 1994.  With inflation fears running high, uncertainty about how close the Fed will come to ruining the economy, high energy and commodity prices, and fears of what will happen in Iran, Iraqall piled on after the Fed’s May 10th meeting to send many to the exits.  The biggest losers were the emerging markets as investors feared that investors’ capital would leave these risky markets as interest rates rise. 

Last week we discussed the abundance of global economic growth and how, so far, it had not been accompanied by excessive inflation.  Even in the face of commodity prices rising straight up, record oil prices, rising wages, and tight supplies in almost all raw material category.  The pressure relief valve is productivity.  It has been rising steadily all over the world, keeping a lid on inflation.