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Rally Faces Big Data Test

A slew of reports, including CPI, will determine if the Fed moves from hawkish rhetoric to action.

The next two days of economic data will go a long way toward clearing up many of the uncertainties expressed in the October


minutes about the direction of the economy and interest rates.

The markets perceived the Fed minutes as slightly hawkish, as they revealed "all meeting participants expressed concern about the outlook for inflation." Those and other comments proved negative for Treasuries on Wednesday, and slightly negative for major equity averages, which ended higher but below their best levels of the session.

The fed funds futures reacted to the minutes by lowering expectations for a rate cut in 2007. Traders are pricing in 0% odds of a cut in January and 14% odds of a cut in March, down from 28% on Tuesday, according to Miller Tabak. The market lowered to 50% its expectations for a cut in May, from 80% Wednesday.

In a passage embedded in the minutes, the Fed outlines the "substantial uncertainty" surrounding its expectations for the economy to expand near its potential growth rate and for inflation to "ebb." The factors that could morph the pause into a hike or a cut include housing, inflation, industrial production and the labor market.

Data from all those parts of the economy roll in Thursday; the day will begin with the consumer price index, which economists expect to fall 0.3% while the core CPI rises 0.2%. Initial jobless claims, industrial production, capacity utilization and the Philadelphia Fed survey, which has been weak lately, follow.

Test Taking

Thursday's core CPI report will test the mettle of the FOMC's pause. Running at a 2.9% year-over-year pace, core inflation is at a 10-year high. If the data push that pace to 3%, the FOMC's tightening bias could become plain old tightening. If they react with words and not actions to watch the housing market's impact, the Fed's credibility will be under a microscope.

The industrial-production and capacity-utilization numbers will clear up for the FOMC members whether, as expressed in the minutes, the "several components of output and demand" that "appeared to have been somewhat weaker than expected" are indeed "temporary influences" and "not likely to depress the pace of economic expansion going forward."

The initial jobless claims can help clarify how dramatic the wage inflation might become. Committee members noted that businesses in several regions of the country reported difficulty hiring skilled workers, but feared such shortages would lead to wage pressure and damage the Fed's forecast for inflation to fall.

Initial jobless claims have reflected the tight labor market better than the constantly revised payrolls data. The four-week average of claims, at 311,000 as of last week, has been in a 306,000-to-318,000 range since early June, according to Last week's claims came in below expectations at 308,000, and the consensus expects claims to come in at 310,000 for this week. If jobless claims continue a downward trend, or if the four-week moving average breaks below 306,000, wage inflation becomes more likely to influence inflation or inflation expectations, putting the Fed on rate-hike alert once again.

At the October meeting, members decided to retained their tightening bias, saying that "inflation risks remained the dominant concern, and that additional policy firming was possible." The committee "viewed the current rates of core inflation ... uncomfortably high and stressed the importance of further moderation," adding that "any such rise in inflation expectations and associated upward pressure on inflation itself would likely prove costly to reverse."

Costly, indeed, for the Fed's credibility and for the bond market, which sold off on those words Wednesday. The 30-year bond dropped 19/32 to yield 4.70%, while the 10-year fell 13/32 to yield 4.62%, and the two-year note fell 4/32 to yield 4.81%.

Key to the Fed's outlook is the housing market, which the committee judged would "remain a substantial drag on economic growth over the next few quarters." Friday's housing starts and building-permits data will clear up whether FOMC members last month were right to be "comforted" from some data that showed "the correction in the housing market was likely to be no more severe than they had previously expected."

Lastly, Thursday brings the November Philadelphia Fed survey of business activity, which has been weak lately and sparked a sharp bond market rally in September when it declined to a reading of negative 0.4 against expectations for a 14 reading. In October, the Philly Fed survey read negative 0.7. This time around, analysts expect a reading of 5.0.

The New York region is faring better, however, as evidenced by Wednesday's strong Empire State Index, which rose to a 26.7 reading for November, from 22.9, and much higher than expectations for a 14 reading in the month.

TheStreet Recommends

The three major stock indices continued on their upward path Wednesday, but peaked at around 2 p.m. when the Fed minutes came out. The

Dow Jones Industrial Average

closed at another all-time high, up 0.28% to 12.251.71. The Russell 2000 also closed at an all-time high Wednesday, up 0.88% to 791.96. The

S&P 500

marked another six-year high, up 0.24% to close at 1396.57, and the

Nasdaq Composite

gained 0.50% to close at 2442.75.

The market's largest gains came from the airline sector, as

US Airways


proposed an unsolicited, $8 billion takeover of bankrupt

Delta Air Lines


. US Air's shares climbed 16.83% on the day, while Delta's shares, which trade as Pink Sheets stock, climbed 3.4%.

Shares of competing airlines climbed in sympathy, with

American Airlines


rising 5.4%,

Continental Airlines

(CAL) - Get Caleres, Inc. Report

jumping 12.30%,

AirTran Holdings


up 15.9%, and

JetBlue Airways

(JBLU) - Get JetBlue Airways Corporation Report

, which also was boosted by a Bear Stearns upgrade, gaining 7.4%.

The Dow Jones Transportation Average gained 1.4% on the day to close at 4830.43, but has yet to "confirm" the Dow's rally to all-time highs by retesting its May 9 high of 4998.95.

Stay tuned for the coming economic data to confirm or put a red light on the steady paths currently being trod by the stock market and the Fed.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


to send her an email.