[Fredslist] Economic Commentary

[Dichter, Dan [PVTC]]

The latest data suggest that economic growth was sound and core
inflation remained contained during the summer, before Hurricane Katrina
made landfall.  Markets shouldn't write off this pre-Katrina information
just because subsequent data likely will be distorted by the storm.
Growth will revert back to its pre-storm path as the economy recovers
from the disaster and energy prices settle down. 

The underlying economic strength so evident in data releases prior to
the storm likely will lead the Fed to tighten policy again at the
September FOMC meeting.  Prior to the hurricane, markets were convinced
that the Fed would lift rates because the data warranted it.  The storm
did not eliminate that imperative to tighten, because it did not alter
the medium-term outlook.

Retail sales fell 2.1% in August, but spending was by no means weak.
More than the entire decline in retail sales was centered in autos,
which took a 12% tumble as the effects of sales incentives faded.  This
widely anticipated decline in auto sales merely reflected how high sales
had soared in July.  In August, unit auto sales settled back to a 16.8
million unit rate, which was close to the average pace over the past six
years, after an eye-popping 20.9 million unit pace in July.

Apart from the swings in autos, recent retail sales figures indicate
that underlying demand was on track before the storm hit. Non-auto
retail sales increased by 1.0% in August and rose 0.5% excluding the
price-induced jump in gasoline station revenues.  These gains imply that
real consumer spending in the first two months of summer was running
more than 4% annualized above the second-quarter average.

Meanwhile, core inflation has remained quite tame in recent months,
despite some huge gains in energy prices.  Excluding food and energy,
consumer prices increased just 0.1% in August, and that was the fifth
consecutive month in which core CPI has hovered in that range. However,
these low readings probably understate the running rate of inflation, as
they offset a surprising early-year spike. Core CPI increased 2.2% year
to year.

The concern is that the recent rise in energy prices might spill over to
core prices.  The 5% jump in energy prices in August and the 16% rise so
far this year occurred before the hurricane hit the Gulf Coast. Since
then, prices have skyrocketed further, reflecting serious disruptions to
the energy supply chain.  For example, national average gasoline prices
gapped to over $3/gallon in the immediate aftermath of the storm. 

We wouldn't be surprised if the jump in energy prices shows up in some
core measures in coming months.  For example, costs of transportation
services that are energy intensive (airfares, train tickets) have begun
to rise. However, any increase in core CPI resulting from higher energy
prices likely would be fleeting.  Energy prices already have begun to
retreat to pre-storm levels, and inflation expectations have remained
impervious to energy-related fluctuations. 

This week's data also showed early signs of the storm's effects on
economic data.  Industrial production was held down by about 0.3
percentage point due to curtailed energy-related mining activity.
Initial claims jumped by 71,000 to 398,000 in the latest week, with
almost the entire rise associated with Katrina.  Also, today's Michigan
sentiment index was adversely affected by the storm and its impact on
energy costs.

As always, please don't hesitate to contact our office with any
questions or needs.

_______________________________________
Daniel G. Dichter
Second Vice President - Investments
Smith Barney | Citigroup Global Markets, Inc.
31 West 52nd Street, 23rd Floor
New York, NY 10019
p. (212) 603-6178
f.  (212) 307-3863
dan.dichter at smithbarney.com



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