Investors watch out for signs of accelerating inflation

NEW YORK -- Last Tuesday, Wall Street got exactly what it was angling for:~ Last week, the Fed lowered the target funds rate by a half-point.

a half-point reduction in interest rates. Now it wants to make sure rates will stay low.

This week, investors will be looking for signs that inflation is under control. If prices accelerate, the Federal Reserve may bump rates back up. The market is also hoping that readings on durable goods demand, the housing market and consumer spending power will show that the economy isn't heading for recession.

The risk of inflation is why the Fed didn't cut rates for four years. Last week, it finally lowered the target fed funds rate by a half-point "to forestall some of the adverse effects on the broader economy" of recent housing, credit and stock market turmoil, and "to promote moderate growth over time." The Fed added, "it will continue to monitor inflation developments carefully," however.

Tuesday's rate cut, along with some strong corporate earnings reports, fueled a 2.9 percent rise in the Dow Jones industrial average last week, a 2.8 percent jump in the Standard & Poor's 500 index and a 2.7 percent gain in the Nasdaq composite index.

It also sent gold prices soaring, crude oil to new record heights, and the dollar plunging. The U.S. currency reached all-time lows against the euro and is now equal to the Canadian dollar for the first time in more than 30 years. A weak dollar benefits U.S. exporters and companies who pull in revenue from overseas, but it can make imports more expensive and dollar assets, like U.S. Treasury bonds, less attractive to foreign investors.

There hasn't been any evidence yet of import inflation, said Jeff Kleintop, chief market strategist at LPL Financial Services in Boston. He noted that many exporters to the United States reduce prices to make up for the dollar's fall. But inflation could accelerate, which would prevent the Fed from lowering rates further or even prompt an increase.

The personal consumption expenditures deflator is released in the Labor Department's Friday report on personal spending. The core PCE, which eliminates volatile food and energy prices, is anticipated to show a year-over-year rise of 1.9 percent, according to the median estimate of economists surveyed by Thomson Financial.

"If we get a PCE that's higher than that, it may suggest the Fed acted too aggressively," Kleintop said. The Fed's comfort zone is between 1 and 2 percent.

Meanwhile, personal spending in August is expected to have risen by 0.3 percent, after increasing by 0.5 percent. Though it's not directly correlated, investors will try to gauge future spending patterns through consumer confidence reports from the Conference Board and the University of Michigan, on Tuesday and Friday, respectively.

Bad news on the housing front has become a given on Wall Street, but market participants will continue to monitor the industry's failing health. On Tuesday, the National Association of Realtors reports on existing home sales and homebuilder Lennar Corp. releases its quarterly earnings. Later, on Thursday, the Commerce Department comes out with its new home sales data, and KB Home posts its earnings.

Because the market has already priced in a weaker consumer and sluggishness in the housing market, business spending "is the leg of the stool that's most important to the economy right now," Kleintop said.

The Commerce Department's Wednesday report on August durable goods orders will be particularly important. Economists are anticipating a 3.1 percent decline, following a solid 5.9 percent advance in July.

The next day, the Commerce Department releases its final measure of second-quarter gross domestic product, and Friday, the Chicago purchasing managers index of September manufacturing activity in the Midwest. The Chicago PMI is seen as a precursor to next week's September manufacturing report from the Institute for Supply Management.

Besides economic data, Wall Street will be watching out for profit warnings from companies ahead of October's flood of third-quarter earnings. Investors are a bit nervous about how corporate America fared during August's stock market volatility and credit tightness, but they are optimistic at this point, particularly given that international growth is a big source of income for many companies.

About 40 percent of earnings in the S&P 500 come from overseas, Kleintop said. "A lot of people think, as goes the economy, as goes the U.S. consumer, so goes corporate earnings. That's not necessarily so."