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ISM, CPI and FOMC: What Are These Acronyms and Why Are They So Important to Traders?

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Recently, OptionInvestor writers were cautioned not to throw out too many of the acronyms seasoned investors use. New subscribers don't always know what they mean.

I identified. As a newbie trader, I barely knew Alan Greenspan's name and had less of an idea what "FOMC" meant. I learned quickly. An FOMC meeting adversely affected a trade that had been rocking along just fine until the statement accompanying an FOMC meeting hit the wires.

In the current climate, traders had better understand something about the FOMC, but they need to go beyond the FOMC. They need a basic knowledge of which reports the FOMC watches. Why? Any one of them can turn a profitable play into a losing one. Quickly.

Don't worry. You're not going to get anything more than the basics in this article. No rants about FOMC policy. No discussions of the relative merits of Greenspan's Greenspeak versus Bernanke's clarity. No deep discussions of economics. I was amused by Greenspan's Greenspeak and don't feel qualified to discuss the rest. The article might be livelier with those rants, however. I warn you that the information, although necessary for traders, prove rather dry.

Let's start with the FOMC. The letters stand for the Federal Open Market Committee, the part of the Federal Reserve that makes policy. This committee sets the federal-funds rate, the rate banks charge each other for overnight loans. The committee also sets the discount rate, the rate the Federal Reserve charges banks for overnight loans at what's termed the "discount window." Those kinds of "discount window" loans are rare now, and it's the other rate, the so-called "interest rate" we hear about on FOMC meeting days, that most rivets traders' attention.

I was intrigued to learn that the FOMC didn't always announce the rate it was setting. According to the Wall Street Journal's book, COMPLETE MONEY & INVESTING GUIDELINE, markets watchers once had to do their best to estimate that rate. While many laughed about Alan Greenspan's obfuscating language, this former Fed chairman's tenure can be credited with providing more clarity for the everyday trader. Rates were published and statements were provided in which the FOMC assessed various economic strengths and concerns.

Chief among those concerns lately has been inflationary pressure, with the fear being that the FOMC will raise rates enough that both businesses and the average person feel the squeeze. I'm old enough and have been married long enough that my husband and I were buying a house during an inflationary era. Our mortgage rate was above 13 percent, and we avoided an even higher mortgage rate only because we had such good credit.

Although current FOMC Chairman Ben Bernanke reassured members of Congress this week that inflation appeared to be under control, markets remain jittery about the prospect of higher inflation and, therefore, higher rates. Relief buoyed markets this week, and that relief certainly impacted traders, adversely impacting anyone caught in a short or bearish trade. Traders have to look back only so far as the stock-market reaction after the release of the minutes of the December 12 meeting to see an opposite reaction. That one also proves that we've been in a period when any signs that the FOMC might have to raise rates again can pummel equity markets. Signs that rates might not have to be raised can buoy them.

Why should that whole interest-rate thing bother stock-market investors? Why are markets reacting so strongly? Homebuyers aren't the only ones borrowing money. Companies need to do so, too, and some companies are hit harder than others when they need to borrow money in a rising-rate environment. Just as my husband and I got a preferential rate during an inflationary period because we had such good credit, companies with good credit get better rates, too. Start-ups, small companies and especially troubled companies pay higher rates. That makes the small-caps more vulnerable to higher interest rates, but rising rates impact all companies. Money gets "tighter," another way of saying that it's harder to get the needed loan to finance new equipment or make other changes.

The FOMC doesn't want to raise rates so high and make money so tight that the consumer and companies both suffer, hurting economic growth. We're also currently in a period in which the economy is softening a bit, a welcome development if all that softening accomplishes is to prevent inflationary pressures from building. The softening is an unwelcome development if the economy softens enough to cascade the economy into a recession. So, both the FOMC and market participants are also closely watching for any signs that the market is softening too much, and that could swing over into the most prevailing concern if the market if such signs appear. The minutes of the December 12 FOMC meeting also mentioned that the economy softened "a touch" more than the committee had expected, so that market bulls were hit twice that month, with worries about inflation growing more than wanted and the economy softening more than wanted. Market bears were hit twice this week, because Chairman Bernanke's testimony was encouraging about both the economy and the lessening of inflation risk.

It should be clear that traders don't want to be blindsided by an FOMC meeting, as I was that time, or even by a speaking engagement, as I know at least one trader was this week despite the newsletter's calendar of events. OIN publishes a calendar in the newsletter each weekend that details the next week's economic events. FOMC meetings and most speaking engagements by FOMC members will be detailed there. If you want to keep the FOMC's schedule bookmarked on your computer, it can be found at http://www.federalreserve.gov/fomc/.

The need to avoid being blindsided makes those other acronyms in the title important, too. According to the WSJ and other sources, the FOMC watches several key economic reports to gauge the inflationary pressures and economic strengths. If the FOMC is watching those reports, traders better be, too. Among those reports are the ISM, the CPI and the jobs data or non-farm payrolls.

ISM stands for the Institute for Supply Management, the entity that produces reports on both manufacturers and service providers. Of the two, the manufacturing ISM is probably still the most important, although our economy is becoming a service-oriented rather than manufacturing-oriented one. On the ISM's website (www.ism.ws), the ISM states that this report is released on the first business day of each month at 10:00 and posted to the website after 10:10 EST.

The ISM surveys manufacturers across the nation, making sure that the manufacturers surveyed are diversified across several industry groups. The resulting report gives traders--and the FOMC--a glimpse into such aspects of manufacturers' business as production, supplier deliveries, new orders, backlog of orders, new export orders, imports, prices and employment. The various components of the group are assigned a percentage, with the ISM site explaining how the percentages and diffusion indices are calculated. You don't need to know how to calculate these. What you need to know is that a number above 50 percent indicates economic expansion and a number below that indicates contraction.

The manufacturing ISM gives the FOMC insight into the health of the economy and inflationary pressures. If the manufacturing sector is expanding too quickly, especially if the employment component is also expanding rapidly, inflation pressures may build.

January's ISM was 49.3, slipping below that 50 benchmark. A number below 50 percent indicates that manufacturing is contracting. One market watcher recently commented that the FOMC won't let that manufacturing ISM remain below 50 percent for too many consecutive months before it cuts rates. Some market participants appear to be betting on that scenario, also betting that the economy won't slip too far. Otherwise, they might not be so bullish on equities, but the current hope appears to be that the perfect Goldilocks scenario of a just-right softening is occurring.

The ISM makes a point of advising those reading its reports that its report is different from the various regional reports on manufacturing, but a couple of those regional manufacturing reports can provide a heads-up to likely changes in the ISM. Those are the Philadelphia Fed Index, the so-called "Philly Fed," and the Chicago PMI. The Philly Fed is released the third week of the month it covers, so it precedes the ISM. This week's past week's release of the February Philly Fed proved disappointing, with the Philly Fed barely clawing out a hold above its benchmark 0.0 level, coming in at 0.6.

The Chicago PMI or purchasing-managers' index also appears before the ISM. It is released on the last day of each month.

FOMC members also purportedly watch the CPI or the Consumer Price Index. This inflationary measure is produced by the Bureau of Labor Statistics in the U.S. Department of Labor and released at 8:30 about the 13th of each month, with the data covering the prior month. The government compiles a basket of goods and services that consumers purchase and releases a figure that shows the percentage by which prices for that basket of goods changed in that prior month.

However, this number is not without controversy. Food and energy products are among the components of that fixed basket of goods, and their prices can fluctuate quite a bit over a month's time. Therefore, the Bureau of Labor Statistics also strips out those goods to produce another figure, the core CPI. Reportedly, this is the FOMC's key inflation measure.

Other market watchers argue that consumers must pay for food and energy, and that these should be included in any inflation measures. I tend to agree, but if it's the core number that the FOMC purportedly watches and to which the market reacts, then that's the one I'm going to watch, too.

How the market reacts to this number depends not only on the number itself, but also on the environment. In 2006, Japanese market watchers wanted to see a rise in their CPI as a sign that the country was pulling out of a long period of deflation. Here in the U.S., though, when market watchers are afraid that the FOMC will go too far and raise rates at least one time too many, market watchers don't want to see an inflationary CPI number.

Traders should also be aware when another number, the PPI, is released, as it was this last week. Although this Producers Price Index is not considered the main inflation guide, a steep rise in the prices producers pay may result in those producers trying to pass on the higher costs to consumers. It can then be a leading indicator of what might happen to the CPI. However, it's not always possible for producers to pass those prices on, so there isn't always a direct this-happens-then-that-happens relationship between the two. This week, some components of the PPI number showed more economic weakening than traders wanted to see, but, ultimately, this number didn't impact markets much this week, either. Then again, it proved hard to tell, since it was released on a day when eight other economic numbers were released and Chairman Bernanke was finishing up his testimony before Congress.

Still, traders should put this release on their calendars, too, since a big surprise, especially one that heightens inflation worries, can sometimes move the markets. This number is released around the 11th of each month and covers the prior month. It's released at 8:30.

A third report that the FOMC reportedly watches closely is known variously as the jobs report, the employment numbers, and the non-farm payroll report. They're all the same thing, differentiated from the weekly initial claims or jobless claims, which is different. The Labor Department prepares this non-farm payroll report and releases it at 8:30 on the first Friday of each month. This number has two key parts, the new jobs created and the unemployment rate, and also includes some less-often-watched components such as the average number of hours worked each week. The unemployment rate measures the percentage of the total work force that is unable to find a job.

When the economy is expanding, new jobs are typically being created, and when the economy is contracting, fewer new jobs are being created. This is a bit simplistic, but the general idea holds. If unemployment rates rise too high, consumers spend less and save more. If that pattern swings too far, demand for consumer goods lessens and the economy is hurt.

That must mean that low unemployment rates are a good thing, right? Not if they're too low. If they're too low, companies must pay high salaries and offer better benefits to attract and keep employees. Chairman Bernanke mentioned this effect this week when he noted that some of his contacts were telling him that it was becoming difficult to find highly skilled or highly placed employees.

That cost of giving incentives to attract or hold key employees builds inflationary pressures. In other climates, market participants might be glad to see many new jobs being created and unemployment rates particularly low, but when the FOMC and other market participants are watching for inflation risks, they don't want those numbers to show that employment costs are adding to those inflation pressures.

A couple of releases help traders gauge how the jobs numbers might shake out, giving a preview. First is the previously mentioned weekly release of initial claims or jobless claims. These come on Thursday mornings at 8:30 and include figures on the number of people filing for new unemployment insurance claims and the number who are continuing to collect on unemployment insurance benefits. Although there's not a direct correlation between the non-farms payrolls and these claims, they do at least provide a window into the employment figures.

A bigger window is provided by the ADP National Employment Report, a number that's been provided to traders over the last year. ADP gathers information during the same time period and using the same methodology as that employed by the Labor Department for its non-farm payrolls number, and produces a measure of non-farm private employment. This number is released the Wednesday before the non-farm payrolls number, providing market participants with an estimate of the non-farm payrolls a couple of days before the government releases those figures. An estimate of government jobs must be added to the ADP's National Employment Report, since that ADP report covers only private-sector jobs. Twice during 2006, the ADP report overestimated the number of jobs, once spectacularly last summer, and it has underestimated, too. It's not a perfect predictor of the non-farms payroll number, but traders need to be aware of its impending release a couple of days before the non-farm payrolls number because markets can often react strongly to this number, ahead of the non-farm payrolls.

Reportedly, former FOMC Chairman Alan Greenspan avidly watched the ECI, the Employment Cost Index, released each quarter, as another measure of employment strength.

Other important indicators of economic health and inflationary pressures exist and are reported throughout the month. Those include, of course, the GDP, or Gross Domestic Product. The Treasury Department releases several versions for each quarter: an initial number that is released a few weeks after a quarter ends, several revisions and then the final number that isn't seen until about three months after a quarter ends. This GDP number expresses the percentage by which the economy has grown or contracted. The market reaction depends on the climate, as it does with other economic releases. Market participants want that Goldilocks scenario in which the economy grows just enough to keep expanding but not enough that inflationary pressures build. The optimum percentage is one that market participants are often forced to guess, as the FOMC doesn't always give a target number they have in mind.

Currently, there's some fear that the next revision of the GDP, due February 28, will show more softening than is optimum or than had previously been anticipated. This week, some experts speculated that the GDP might be revised to show growth of only 2.2 percent, down from the previous 3.4 percent. You might add that February 28 date to your trading calendars and make decisions about whether you want to hold trades open ahead of that release.

Other measures that can impact trading are Housing Starts, Retail Sales figure and Consumer Sentiment, among others that I'm probably forgetting. However, those figures are often more easily understood, while new market participants sometimes don't understand the ramifications and importance to the FOMC of the ISM, CPI and non-farm payrolls. Keep on the watch for these three releases, because they can swamp a previously profitable play. In particularly volatile times, when markets perch precariously just under resistance or just above support, these releases can change the trading environment.

Conservative traders sometimes elect to exit trades before an important release, such as one of these. That's a decision for each trader to make. Hopefully knowing which of the reports is likely to be most important will help you formulate your plan and avoid being blindsided as I once was.

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