Mr. Bernanke: Retail sales or GDP growth?

Will Fed Chairman Bernanke base his interest-rate decision on 4% GDP growth in the second quarter, essentially looking through the rear view mirror, or on virtually every other data point that suggests the economy is slowing down?

Bernanke deserves plaudits for his handling of the economy, particularly halting rate increases knowing changes in Fed policy take time to impact the economy. Something Greenspan might not have done.

Bernanke's most important signal on where the economy could be is the 10-year bond that has crashed from 5.2% in late 2006 to 4.47% today. However, Ethan Allen Interiors Inc (NYSE: ETH) CEO Kathwari said yesterday at Goldman's retailer conference "our retail written sales on a comparable store basis were up modestly in June and July. This positive trend has continued in August." This is by no means a glowing review of the economy, but neither is it a sign of an economy in deep despair.

Meanwhile, the pending home sales index crashed 12.2% in July versus June, dropping to the lowest level since September 2001. Since the index tracks existing-home contract signings, not final sales, it is considered a leading indicator and suggests a big drop in home sales in August or September.

From all the evidence, the Fed should start dropping rates. With the drop in the discount having some calming effect, look for the Fed to start with a 25 basis point basis cut followed by two more to finish up the year.