Volume 7, Issue 20

Volume 8, Issue 3

February 8, 2010

The Federal Reserve/Monetary Policy

·   There were two surprises in the Fed's January 27 policy statement. First, the Fed upgraded its near-term economic recovery outlook to moderate from weak and the Kansas City Fed president dissented from the policy statement because he believed economic conditions had improved enough to drop the expectation that the fed funds rate would remain low "for an extended period." Both of these moves were vindicated by the subsequent fourth quarter GDP report showing the strongest quarterly growth in years. Nevertheless, the Fed will continue a stimulative policy and the funds rate will probably be <0.25% through at least the 3rd quarter, but more policy dissents are likely if the moderate recovery continues and the majority of Fed policymakers vote to keep the "extended period" expectation.
·   Bernanke was reconfirmed by a 70-30 Senate vote, the closest vote in history for a Fed Chair. While the vote raises concerns about the Congressional meddling in monetary policy, Bernanke at least emphasized the importance of Fed independence in his acceptance comments.
·   Monetary policy appears stimulative based on a 0.13% average Fed funds rate in recent weeks, a 130% jump in Federal Reserve credit over the past 16 months, and Fed direct support of credit markets, such as the Fed's purchases of $1.15 trillion of mortgage-backed and Federal agency securities. However, the decline in bank loans is the steepest since the Great Depression and very rapid money growth in 2009 has unwound. On Friday, bank regulators issued a joint statement encouraging banks to make loans to creditworthy small businesses. The economic trauma of the past year has no doubt impacted expected consumer, business and investor behavior, which raises uncertainty about just how stimulative monetary policy is.
·   Fiscal policy appears stimulative with the Federal deficit at unprecedented levels. The high unemployment rate is the short-run political priority. With interest rates still low, the Administration and Congressional majority will press for more stimulus programs. The President's recent budget proposal shows a bias toward higher spending and taxes. Longer run, prudent U.S. fiscal policy requires a cut in entitlement - Medicare, Medicaid, Social Security - benefits, just as pension obligations will have to be cut at many state and local governments.

The Economy/Inflation

·   Aggregate dollar demand (current dollar GDP) started growing at a 2.6% rate in the third quarter of 2009 and that growth accelerated to a rapid 6.3% rate in the fourth quarter. This is mainly the result of monetary policy stimulus - politicians (and their short-run fiscal policies) take way too much credit for and get way too much blame for short-run economic developments.
·   Real GDP jumped at a 5.7% rate as production rose to slow inventory liquidation and as exports and business equipment spending rose strongly. House building rose at a 5.1% rate but real consumer spending rose at a much more modest 2% rate.
·   Real GDP growth will slow this quarter because production is catching up with demand but the economic recovery is very likely to endure. Aggregate dollar demand (nominal/current dollar GDP) and top-line corporate revenue should rise 4+% in 2010 and 5% in 2011 vs. -1.3% in 2009. Real GDP should rise a moderate 3% this year and 3+% in 2011. Such rates of growth wouldn't be enough to reduce unemployment much. The recovery will continue to be led by business investment in inventory and equipment, exports, housing and Federal government purchases. Consumer spending will lag and commercial construction will decline.
·   In its January 27 policy statement, the Fed said again that "...inflation is likely to be subdued for some time." Core inflation currently appears to be running at or below the low end of the Fed's perceived comfort zone of 1.5% to 2%. Commodity prices have dropped sharply and the dollar has risen in currency markets. Unit labor costs were 2.8% below a year ago in the fourth quarter and the employment cost index was only 1.2% above a year ago in the fourth quarter. The 10-year inflation rate forecast implied in Treasury inflation-protected bonds (TIPs) yields was a moderate 2.27% at Friday's close.

Financial Markets

·   Policy uncertainties and credit concerns about Greece, Spain and Portugal triggered a mini "Flight to Quality" in credit markets the past three weeks. Financial and commodity markets were ripe for a sell-off following their previous sharp rallies. The drop in commodity prices and decline in Treasury bond yields should cushion the decline in stocks. Lower commodity prices reduce consumer costs and have a positive impact on most businesses.
·   Fundamentally, the Fed's monetary policy should remain supportive of markets, i.e. negligible short-term interest rates will keep investors seeking higher yields in stocks, bonds, and commodities.
·   Sustaining the economic recovery will likely require stock market strength. Stocks appear somewhat undervalued vs. Baa corporate bonds (Stock Market Barometer). Based on forecasted 2010 earnings (subject to considerable forecast error), the price/earnings ratio for the S&P 500 at Friday close was 14.2 versus a 19.4 average over the past 21 years.
·   There is a good chance stocks will outperform Treasury bonds and cash in the year ahead, but the strongest part of the rally - fueled by collapsing high-yield bond yields - has probably already occurred.
·   Credit quality bond yield spreads widened a little in recent days, but yield spreads remain in their historical normal range (Bond Market Barometer). Treasury bonds may slightly under-perform other bond sectors as Treasury bond supply rises to fund the large federal deficit. The economic recovery isn't likely to be strong enough to push long rates up substantially this year, but there is some risk that large federal deficits will push up rates more than expected.
·   Mortgage rates remain low and mortgage lending has picked up. If the Fed ends its mortgaged-backed purchases at the end of March as planned, mortgage rates will likely rise somewhat relative to Treasury bond rates.
·   A number of companies have restored or increased their stock dividends this year and the dollar dividend on the S&P 500 bottomed at year end.

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Economic Outlook

2009

2010

Annual Average

Qtr. 4	Q1	Q2	Q3	Q4	2008	2009	2010
5.7	2.8	2.6	2	3.3	0.4	-2.4	3
2.7	1.5	1.5	1.4	1.4	3.3	0.2	1.9
1.4	1.5	1.3	1.3	1.3	2.4	1.5	1.4
3.47	3.85	3.9	4.1	4.25	3.67	3.26	3.98
0.15	0.13	0.15	0.15	0.4	1.98	0.18	0.21
16.21	17	18.4	19.65	20.25	49.51	56.4	75.3
n/a	68.2	33.2	24.5	21.3	-40	13.9	33.5
5.66	5.75	5.95	6	6.1	28.38	22.41	23.8
-20.8	-3.5	9.4	12.1	7.8	2.3	-21	6.2
1083.3	1100	1190	1225	1250	1221.3	944.8	1191.3
18.8	36.2	33.4	23	15.4	-17.3	-22.6	26.1

Real GDP, % annual rate

Inflation, PCE % an. rate

Core inflation (ex food&energy)

10 Year Treasury bond (%)

Fed funds rate (%)

S&P 500 operating earnings($s)

S&P 500 op. earn. Yr/Yr % chg.

S&P 500 dividends ($s)

S&P 500 div Yr/Yr % chg.

S&P 500 Index (average)

S&P 500 Index, Yr/Yr % chg.

Economic and Financial Data

Disclaimer

The material herein is based on data from sources considered to be reliable, but it is not guaranteed as to accuracy, does not purport to be complete and is subject to change without notice. It is not to be construed as a representation by us or as an offer or the solicitation of an offer to sell or buy any security. Any opinions expressed are subject to change. From time to time, this firm, its affiliates, and/or its individual officers and/or members of their families may have a position in the subject securities which may be consistent with or contrary to the recommendations contained herein; and may make purchases and/or sales of those securities in the open market or otherwise. This communication is for informational purposes only. Use by other than intended recipients is prohibited. Sender accepts no liability for any errors or omissions arising as a result of transmission. Any comments or statements made herein do not necessarily reflect those of Reliance Financial Corporation or its affiliates.

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Arnie Dill, Ph.D.
Consulting Economist