Judging by yesterday's data updates, there are at least two more reasons to worry and wonder about the future. Import prices and retail sales provide fresh incentives to stay cautious.

Let's start with import prices, which are now rising by 13.6% a year as of last month, the U.S. Bureau of Labor Statistics reported. That's sky high by recent standards, as our chart below shows. Energy imports are, of course, driving the trend, although non-petroleum import prices are also rising at a robust pace of 4.5% over the past year. By comparison, U.S. consumer prices rose by 4.3% for the year through January. Any way you slice it, the United States is importing inflation, adding momentum to the domestic inflationary fires already smoldering.

Meanwhile, retail sales took a hit last month, according to the U.S. Census Bureau, falling 0.6% in February. That's the steepest monthly decline since last June. More worrisome is the longer-term trend. As our second chart below illustrates, year-over-year retail sales continue slipping, as they have been for the past two years.

From a price stability perspective, lowering interest rates looks irresponsible at this point. With inflationary pressures bubbling, printing more money will only add fuel to the trend. Indeed, the dollar continues to weaken, which is helping pump up import prices. If the Fed continues to cut interest rates, the buck may plumb even lower depths. The U.S. Dollar Index is already at all-time lows, and no one should discount the possibility that more selling awaits.

But what's irresponsible from the perspective of monetary policy may look necessary from another vantage. The Fed is under growing political pressure to inject more liquidity into the economy and slow the slowdown. It remains to be seen how effective the central bank's tools are for the task at hand. Meanwhile, the market expects lower rates: the May '08 Fed funds futures contract is priced in anticipation of a 100-basis-point drop in Fed funds.

Commodities and foreign bonds denominated in currencies other than the dollar will probably fare well in this climate, although the strong gains in those asset classes don't encourage us to favor huge overweights in those areas. In fact, paring back weights in foreign bonds and commodities looks more prudent as prices in those areas runs higher. Meanwhile, stocks and domestic U.S. bonds still look vulnerable and the TIPS market has already enjoyed a strong run over the past year.

Strategic investors may reason that the best action is standing back and letting the process unwind. Corrections eventually burn themselves out, the only question is when. By your editor's reckoning, it still seems early. The system hasn't been sufficiently purged. Meanwhile, the Fed must at some point hike interest rates to soak up the liquidity it's throwing around to stave off recession and ease the credit crunch. It's unclear when those hikes will come, but when they do the markets will have a yet another challenge to digest.

In short, this story has a ways to go. Meantime, defense is still the priority du jour.

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James Picerno

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