Data Put Fed in a Pickle

Friday's numbers underline recent suggestions that growth is slowing and inflation is picking up.
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Strong presidential words and solid economic numbers started the market off smartly Friday, but traders lost their spirit a bit as they picked through the day's smorgasbord of data.

A report on personal income and spending from the Commerce Department set a positive tone early. The government said incomes rose 0.6% in March, beating expectations for a gain of 0.4%. February's pace was revised up to plus 0.4% from up 0.3%.

Those numbers, and a Labor Department report suggesting U.S. companies' first-quarter employment costs were lighter than expected, pushed major stock indices higher at the open.

Wage growth has been a laggard on the employment scene, even as the economy has been adding new jobs at a faster clip, according to payroll data. So any improvement there brings hope that the economy can power through the rough patch that left it with a disappointing 3.1% gain in gross domestic product in Thursday's first-quarter advance reading.

But a closer look at Friday's report reveals that inflation pressures offset the income gains. The price index for personal consumption expenditures, an inflation gauge watched closely by the

Federal Reserve

, rose 0.5%, pushing its 12-month rise to 2.4%. The core index, excluding food and energy prices, rose 3%, pushing its 12-month increase up to 1.7% from 1.6%.

"The report confirmed the continued tilt upward in core

inflation that has the Fed on heightened inflation watch," wrote Peter Kretzmer, senior economist with Bank of America, in a research note. "Personal income rose 0.5% in March, but higher prices eroded any increase in purchasing power. Real disposable personal income was flat in March but remains a solid 3.3% above a year earlier."

Inflationary pressure also sucked wind out of the spending side of the report. The government said consumption rose 0.6% in March, topping economists' estimated 0.4% growth. But adjusted for inflation, spending rose a paltry 0.1%. Real spending on durable goods rose 2.2%, powered by an uptick in auto unit sales. Real service spending also rose a healthy 0.3%, but a 1% drop in real, nondurable goods purchases accounted for much of the weakness.

"After roaring into the year on a robust note, real spending clearly slowed in March despite an increase in auto sales and moderate service spending gains," Kretzmer said, forecasting annualized real consumption growth of 2.5% for the second quarter, down from 3.5% in the first quarter.

Adding to gloom on the consumer spending front, the University of Michigan said its consumer sentiment index slid to 87.7 in April from the preliminary reading of 88.7 and the 92.6 logged in March. That followed news from the Conference Board that its consumer confidence index dropped to 97.7 in April from 103 in March.

These two gauges of consumer attitudes appear to be going back into a decline that prevailed through the back half of 2004 -- until holiday shopping and a postelection rally in the stock markets buoyed spirits. The development has raised the specter of a potential slowdown in consumer spending under the weight of high gas prices, rising interest rates and rising debt levels. Such an event could prove a considerable blow to an economy that has long depended on strong spending from American consumers. Still, many observers claim such fears are overblown.

In the industrial sector, the National Association of Purchasing Management said its Chicago purchasing managers' index dropped to 65.6 in April from 69.2 in March. Despite the decline, the results were better than Wall Street's forecast, which called for a drop to 62.5. The employment and the new orders components of the report fell but remain at strong levels, while inventories rose, matching news from Thursday's GDP report.

The upside to estimates in the purchasing managers' provided hope for investors weighing the sharp divergence between two recent regional reports on industrial activity that roiled markets. The Philadelphia Fed reported its manufacturing index jumped to 25.3 in April from 11.4 in March, blowing away estimates. Meanwhile, the New York Federal Reserve Bank said its Empire State Manufacturing index plunged to 3.1 in April, the lowest reading since April 2003, from a revised 20.2 in March.

Taken together with Thursday's GDP report, the latest data paint a picture of a slowing economy with signs of rising inflation. The situation creates a difficult balancing act for the Fed heading into its meeting next week, where most investors expect the central bank to continue its measured campaign of raising interest rates by a quarter-point for the eight month in a row.

"The Fed is in a position here where we've seen some slower economic growth, and we've seen some signs that inflation is rising a little bit stronger than the Fed would like," says Michael Sheldon, chief market strategist with Spencer Clarke LLC. "Inflation is a lagging indicator in the economy, so it's certainly possible that inflation may continue to edge up while the economy is slowing.

"That makes it difficult for the Fed because they have a balancing act between growth and inflation," Sheldon adds. "How that plays out for the next few quarters will probably determine the strength of the economy and the path of the stock market in the months ahead."