A tame reading of February consumer prices helped propel stocks and bonds higher Thursday, while gold and the dollar dropped.

The consumer price index rose 0.1% last month, down from 0.7% in January and in line with expectations. Excluding food and energy, the core CPI also rose 0.1%, down from 0.2% in January and less than the 0.2% economists expected.

The conclusion drawn by markets is that tame inflation, together with a slowing housing market, will prompt the Federal Reserve to stop raising interest rates sooner rather than later.

The benchmark 10-year Treasury bond jumped 20/32 while its yield, which moves inversely, dropped to 4.64%. Rising bond yields had been rising steadily over the past few weeks, putting competitive pressure on stocks.

Yields were rising partly due to economic strength in January, which persuaded some participants that the Fed will lift the fed funds rate to 5.25%. Long bond yields, which partly reflect inflation expectations, rose accordingly from a January low of 4.33% to 4.78% on Monday.

But this week, a series of economic data, including weak February retail sales on Tuesday and now a tame CPI -- as well as a weaker-than-expected Philadelphia Fed index and higher-than-expected weekly jobless claims -- are relieving some inflation anxiety.

That's also good news for stocks, which had been pressured not only by rising bond yields but also by concern that the Fed would "overshoot" -- hiking rates too much and possibly bringing economic growth to a halt.

The Dow Jones Jones Industrial Average was recently up 66 points, or 0.6%, to 11,276. The S&P 500 rose 0.5% to 1309 and the Nasdaq Composite gained 0.4% to 2320. Both the Dow and the S&P were at levels unseen in more than five years.

Rate-sensitive issues, such as homebuilding stocks, were sharply higher. The Philadelphia housing sector index was recently up 1.7%, lifted by strong gains in the likes of Toll Brothers ( TOL), Standard Pacific ( SPF) and KB Home ( KBH).

Financial issues were also higher after Bear Stearns ( BSC) posted strong earnings, joining the likes of Goldman Sachs ( GS) and Lehman Brothers ( LEH). Bear Stearns, however, was lower as a settlement with regulators took off some of its shine.

The dollar, which has remained supported by the Fed's 20-month-long campaign to tighten monetary policy, dropped against both the yen and the euro. Likewise, gold, which is used as a hedge against inflation, was recently down $2.10 at $552.30 an ounce.

Indicating Inflation

The market's reaction to Thursday's data shows how much inflation has become an issue in traders' minds in the first few months of 2006. It's likely to remain an issue, despite the February CPI.

A good way to measure the market's inflation expectations is the spread between the yield of the 10-year Treasury bond and that of a Treasury inflation-protected security, or TIPS. The spread, currently at 2.55%, remains elevated from its December level, where it stood at 2.29%, notes Tony Crescenzi, interest rate strategist at Miller Tabak and a RealMoney contributor.

Fed Chairman Ben Bernanke has indicated repeatedly that what has kept soaring energy costs from seeping into core inflation was that inflation expectations have remained contained. But they increased markedly since the beginning of the year, and that's likely to keep Bernanke on inflation watch.

"There's a little bit of an inflation threat," says Kim Rupert, fixed income analyst with Action Economics. "It's not profound but it's there."

Energy prices, although they've stopped rising, remain elevated, starting with crude oil, which remains above $60 per barrel.

A tightening labor market also threatens to add to inflation pressures, as seen last week with a strong February jobs report and an unemployment rate still below 5%. On Thursday, however, initial jobless claims rose by 5,000 in the week ending March 11, to 309,000. This is higher than Wall Street's estimated 298,000 and the largest count year to date.

The fact that the 10-year Treasury bond yield has risen is doing some of the Fed's work, Rupert says. The yield is used to benchmark mortgage rates and also corporate borrowing costs.

But some Fed officials believe that credit markets remain accommodative. "Despite the removal of very accommodative Fed monetary policy, credit markets are still accommodative in my view,'' Atlanta Fed President Guynn said Wednesday, according to Bloomberg. Guynn votes on interest rate decisions this year.

The European Central Bank and, more cautiously, the Bank of Japan, are also moving toward removing some of the excess liquidity seen in global financial markets over the past few years.

The big issue for the Fed remains the housing market, which has been the main driver of economic growth over the past few years but has been slowing down since last summer. Consumers withdrew $600 billion from their home equity to finance purchases in 2005, according to former Fed Chairman Alan Greenspan.

It would be tempting to view weaker retail sales in February as a sign that a slowing housing market is already impacting consumer demand, which would take the Fed out of the equation. But economists believe that because January's numbers were boosted by unusually warm weather and post-holiday gift-card redemptions, February's weakness is a normal payback.

According to Lehman Brothers' chief economist Ethan Harris, the interplay between a slowly cooling housing market and underlying economic growth will be key in determining when the Fed stops raising rates. Harris believes the Fed will hike four more times this year, taking the fed funds rate to 5.5%.

Although the housing market is cooling off, the economist believes it's a slow process while underlying economic strength remains strong. The government said housing starts slipped to an annualized rate of 2.120 million units, against economists' expectations of a 2.030-million-unit pace. January's result was revised up to 2.303 million.

"It will probably take longer for the diminishing housing wealth effect to overcome an even stronger underlying trend in growth," Harris wrote in a note.

It seems once again that markets are hoping to have the Fed out of the way a bit too early.
In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.

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