Economy Still Showing Strength, While Inflation Stays Moderate

The economy showed several signs of strength in December, while inflation grew only moderately.

Fresh economic data showed a rebound in Mid-Atlantic factory activity and surprising strength in the housing market. This coupled with a continued tight labor market bodes well for future growth, even though some economists warn some of the data could have benefitted from warmer-than-expected weather in December.

The number of newly laid off workers filing claims for unemployment benefits fell to a seasonally adjusted 290,000 last week, the lowest level in 11 months and an indication that the labor market began the new year in good shape in spite of weakness in housing and auto manufacturing. Continuing unemployment claims jumped 120,000.

Meanwhile, the Commerce Department reported that construction of new homes rose by 4.5% in December to a seasonally adjusted annual rate of 1.642 million units. The number, which was the strongest since September, raised hopes that the worst of the housing slowdown may be coming to an end.

Mid-Atlantic Factory Activity Rebounds

Factory activity in the Mid-Atlantic region rose in January after falling in December, according to a survey released this afternoon.

The Philadelphia Federal Reserve Bank said its business activity index rose to 8.3 in January, its highest level since August 2006, from a revised -2.3 in December. Wall Street analysts had forecast a rise to 3.0.

A reading above zero indicates growth in the region's manufacturing sector.

"It's another signpost that the economy is on a good track," said Lynn Reaser, chief economist with Banc of America Capital Management. "For the overall economy, it shows that the one-fifth that the manufacturing sector occupies is beginning to firm, while the service sector remains on an expansion track."

Earlier, the Labor Department said consumer prices jumped 0.5% in December, in line with average estimates from economists, as gasoline prices staged a momentary rebound.

However, with crude oil prices setting 20-month lows in recent weeks, the expectation is that gasoline costs will resume their downward trend and stay well below the record level of over $3 per gallon, set last summer.

When the volatile food and energy sectors are excluded, the so-called core CPI rose 0.2% in December, also in line with estimates.

CPI Up 2.5% For 2006

For all of 2006, consumer prices rose by 2.5%, the best showing since prices had increased by just 1.9% in 2003.

Energy costs were up 2.9%, a significant slowdown after an increase of 17.1% in 2005 and 16.6% in 2004. That price moderation occurred in recent months. After advancing at a 22.8% annual rate in the first six months of 2006, energy costs fell at a 13.4% rate in the final half of the year.

However, analysts cautioned that all of the figures, especially the housing data, may have been heavily influenced by warmer-than-normal weather last month.

"I still want to see what some of the extraordinarily warm weather sort of passes through some of the data," said Stuart Hoffman, chief economist at PNC Financial Services Group, on CNBC's "Squawk Box." "It might not look quite so strong in February and March. Certainly, though, these numbers put a dagger right through the heart of all the doomsday and gloomsters who were calling for a recession and no growth in the economy this year."

While underlying inflation pressures have softened from the middle of last year, the moderation isn't likely to be deep enough to convince Fed officials that price pressures are no longer a threat to the economy. Many in the market expect this means the Fed will hold the federal funds rate at 5.25% for the fifth-straight time. The interest-rate setting Federal Open Market Committee will meet again on Jan. 30 and 31.

This morning, Cleveland Federal Reserve President Sandra Pianalto said financial markets seem confident that the Fed will bring inflation back down, but she said there is still a risk that underlying inflation will not improve and the Fed will have to act.

"We have several measures of inflation expectations to look at, and they all generally suggest that long-term inflation expectations are holding steady," Pianalto said in a prepared text for a speech in Dayton.

CPI May Overstate Inflation

In testimony before the Senate Budget Committee today, Federal Reserve Chairman Ben Bernanke said the CPI may overstate annual inflation by as much as one percentage point.

"We do think...that standard CPI does overstate true inflation - if we could measure true inflation - by some amount between one-half and one percentage point," Bernanke said, during the hearing.

In Bernanke's prepared remarks, he offered no new clues about his views on monetary policy. Instead, he warned the senators that the recent narrowing of the U.S. budget deficit is simply the "calm before the storm."

Without changes in legal policy, he expects higher entitlement spending could cripple the economy, he said.