Introduction

Cracks in the second quarter first began to appear in May with a surprise decline in retail sales that was repeated just this last week with another decline for June. The trouble with inflation, or more accurately its absence, first appeared back in March as core consumer prices posted a very rare decline. And of all the data we've seen so far this year, whether retail sales or manufacturing production or wages, no set is setting off the alarms like the CPI.

The economy

Consumer price data go back exactly 60 years and on only a handful of occasions, the last during the Great Recession and then back in the early 80s, have results been as weak as they have over the last 4 months. The stumble started in March with the first decline in the core rate (ex-food & energy) since 2010 and only the 8th monthly decline in all of history. And prices, not getting any lift at all from wages, have not improved much since, rising a rounded 0.1 percent in each of the last 3 months.

Janet Yellen, in her FOMC press conference, defended June's rate hike by citing special factors in the core. What indeed pulled down the core in March was a 7.0 percent plunge for wireless telephone services as providers entered an all out price war. And this subcomponent, which makes up 1.5 percent of total prices, is still going down with June's dip at 0.8 percent. Yellen further pointed to pharmaceuticals as a second special factor. This makes up 1.4 percent of total prices and is in fact already starting to rebound.

But what Yellen didn't say was that some big components are moderating. Housing, making up 43 percent of the CPI, has been topping out at the 3 percent annual line. And medical care, at 9 percent of the CPI, is moderating sharply to below 3 percent. Other core prices are also soft including transportation, which represents 6 percent of the CPI and where vehicle prices are down month after month, and also apparel, at 3 percent of the CPI and in outright annual contraction at minus 0.7 percent.

But damage to key annual rates has so far been limited. The core is at 1.7 percent which is a 2-year low but still within striking distance of 2 percent. Total prices are at 1.6 percent and could move higher should food and energy costs show life. But these prices have been flat with food unchanged in June for only a 0.9 percent annual gain and energy down a monthly 1.6 for a yearly gain of 2.3 percent. For the energy outlook, the price of oil, starting at $57 this year and down $10 since, isn't a plus.

The week's other jolt comes from retail sales which closed out a poor second quarter with a poor showing in June. Annual sales are under 3 percent for the first time since August last year with the 3-month average below 4 percent. Month-on-month, retail sales fell both in June, down 0.2 percent, and May, down 0.1 percent. Here too key categories are weak including vehicles and restaurants. Retail makes up only 1/3 of total consumer spending, so spending on services can still bail out the quarter.

And based on the consumer's assessment of current conditions, service spending could very well show strength in June. The current conditions index of the consumer sentiment report remains at long-term highs, over 110 since the election. But there's a crack here too. Expectations, barely at 80, have delinked from current conditions in what may be a signal of trouble later this year. Sagging confidence among Republicans is behind the dip with pessimism deep and steady among Democrats.

There's also key news out of manufacturing and here the message is less ominous. The manufacturing component of the industrial production posted a gain in June but only a small one at 0.2 percent. Output has been unsteady the last four months and stands in sharp contrast with all the consistent strength seen in private reports like the ISM or regional reports like the Philly Fed. But this is a unique feature of the post-election economy: strong signals for sentiment not panning out in the real economy.

The week does include a tangible plus for the second quarter and that's business inventories which rose 0.3 percent in May to offset a 0.2 percent draw in April. Inventory build is a plus in the GDP calculation though rising inventories are not always consistent with rising demand and can be the result, at least initially, of slowing demand. Retailer inventories made the difference in May as vehicles at dealers spiked. But high inventories of vehicles, where sales have been weak, may not be a plus at all.

Markets: Yo-yo yields, climbing stocks

Bond yields have been volatile with the 10-year Treasury jumping from 2.15 percent late last month to nearly 2.40 percent following June's strong payroll result and now falling back to nearly 2.30 percent after the CPI and retail news. Underlying demand for Treasuries hints at underlying doubts over economic strength. But that's bonds. The stock market had yet another positive week with the Dow, ending at 21,637, posting a run of records to stand at a sizable year-to-date gain of 9.5 percent.

The bottom line

The week is perhaps best summed up by the Fed's own Beige Book which downgraded the general assessment of economic strength from modest-to-moderate to slight-to-moderate. The Beige Book does warn of tight conditions in the labor market, that is lack of available labor relative to demand for labor, but its assessment of ongoing wage gains is flat while its assessment of general inflation is soft. It may after all be the lack of inflation that's keeping consumers content with limited wage growth, and certainly weak wages are consistent with weak retail spending. The second quarter was supposed to be a grand one after the first quarter's slowdown, but it doesn't look like it's shaping up that way.

Week of July 17 to July 21

With consumer weakness a concern, strength in the housing sector is more important than ever for the economy. Home builders have been very optimistic and have been keeping the housing market index at elevated levels, levels however that have not been matched by housing starts and permits which have been sagging. The home builders report will come out on Tuesday followed by starts on Wednesday with updates on the factory sector coming out on Monday, with Empire State, and Thursday with the Philly Fed. Inflation, which proved very weak in June, will be revisited at the cross-border level with import & export prices on Tuesday.

Monday

Empire State Index for July

Consensus Forecast: 15.0

Consensus Range: 10.0 to 18.3

The Empire State report isn't hot every month but it was in June with a 19.8 reading that forecasters see slowing to what would be a still very strong 15.0 in July. Order readings were very solid in June which points to general strength in July's activity.

Tuesday

Import Prices for June

Consensus Forecast, Month-to-Month Change: -0.3%

Consensus Range: -0.5% to 0.1%

Export Prices

Consensus Forecast, Month-to-Month Change: 0.0%

Consensus Range: -0.2% to 0.2%

Consumer prices and producer prices were both weak in June and similar results are expected for import and export prices. Import prices in June are expected to be pulled 0.3 percent lower largely by low energy prices. Export prices, where food prices are focus, are expected to come in unchanged.

Housing Market Index for July

Consensus Forecast: 68

Consensus Range: 65 to 69

Optimism among home builders has been fading in recent months but remains very high, at 67 for the housing market index in June with July's Econoday consensus at 68. Expectations for future sales have been this report's key plus with the traffic component showing on-and-off again strength.

Wednesday

Housing Starts for June

Consensus Forecast, Adjusted Annualized Rate: 1.170 million

Consensus Range: 1.120 to 1.201 million

Building Permits

Consensus Forecast: 1.206 million

Consensus Range: 1.170 to 1.225 million

Housing starts and permits proved unexpectedly weak in both April and May and forecasters are calling for sizable rebounds in June, to a 1.170 million annualized rate for starts vs May's 1.092 million with permits seen at 1.206 million vs 1.168 million. Condos have been especially weak but less so for single-family homes which should be a plus for construction spending. This report will offer key updates on housing's contribution to second-quarter GDP.

Thursday

Initial Jobless Claims for July 15 week

Consensus Forecast: 245,000

Consensus Range: 240,000 to 250,000

Demand for labor is very strong reflected in jobless claims which are at historic lows. Forecasters sees initial claims coming in at 245,000 in the July 15 week vs 247,000 in the prior week. Note that the July 15 week was also the sample week for the July employment report which will add focus to this report.

Philadelphia Fed Manufacturing Index for July

Consensus Forecast: 23.5

Consensus Range: 15.0 to 34.2

Growth in the factory sector is uneven but strength in the Philadelphia Fed index has been exceptional. The index came in at 27.6 in June with Econoday's July consensus at 23.5. Order readings are at extraordinary levels in what points to overheating for the sample's respondents.

Index of Leading Economic Indicators for June

Consensus Forecast, Month-to-Month Change: 0.4%

Consensus Range: 0.2% to 0.5%

The index of leading economic indicators slowed the last two reports to gains of 0.3 percent in May and 0.2 percent in April but a snapback to 0.4 percent is the call for June. Low interest rates and low jobless claims have been consistent positives in this report.