Volume 7, Issue 20

Volume 8, Issue 5

March 8, 2010

The Federal Reserve/Monetary Policy

· In the press release following its March 16 policy meeting, the Fed will likely say that economic activity has continued to strengthen and that inflation should be subdued for some time. Before too long, the Fed will need to bite the bullet and stop promising to keep the Fed funds near zero for an extended period, but probably not at next week's meeting. At least one committee member is likely to dissent, saying that conditions no longer warrant the expectation of a low funds rate for an extended period.
· The Administration is contributing to the job shortage by not nominating candidates for Fed governor openings, which will soon total three out of seven governor positions. The risk is that markets will be roiled by the nomination and appointment of inflation doves given the political bent of the Administration and Congress. Hopefully incoming Fed governors will value low inflation and Fed independence.
· Monetary policy appears stimulative based on a negligible Fed funds rate and an unprecedented jump in Federal Reserve credit and Fed direct support of credit markets. However, a decline in bank loans is the steepest since the Great Depression and very rapid money growth in 2009 has unwound. Given the unprecedented Fed actions of the past 16 months, there is even more uncertainty that usual about the impact of current monetary policy.
· In his recent Congressional testimony, Bernanke said "....it is very, very important for Congress and the Administration to come to some kind of program....that will credibly show how the United States government is going to bring itself back to a sustainable position..." He said deficits need to be brought down to 2.5% to 3% of GDP compared with the current 10+%. He warned that financial markets could react tomorrow (shun U.S. debt and raise interest rates a la Greece) "... if bond markets are not persuaded that Congress is serious about bringing down the deficit over time." Prospects for serious deficit reduction (must include Social Security, Medicare, Medicaid) are poor with interest rates still low and an election approaching.
· A recovering economy could be a plus for incumbents by the November elections. Much credit for any recovery will be claimed for the "stimulus" spending. However, monetary policy and financial market rescues should probably get the most credit.

The Economy/Inflation

· While economic growth this quarter will slow from last quarter's rapid 5.9% pace - a small part of which is due to a weather snow job -- the economic recovery is very likely to endure. Aggregate dollar demand (nominal/current dollar GDP) should rise 4% in 2010 and 5% in 2011 vs. -1.3% in 2009. Real GDP should rise 3+% this year and next vs. a -2.4% in 2009. 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 decline.
· During the severe recession last year, employers were able to reduce hours worked by much more than they cut production, meaning productivity rose sharply. Since compensation growth also slowed, unit labor costs in the non-farm business dropped 1.7% in 2009 and such costs were a very sharp 4.7% below a year ago in the fourth quarter. While these gains in productivity are very positive for long-run growth and inflation control, they explain the lack of job growth and high unemployment rate. Although commodity prices rebounded last week, core consumer inflation appears to be at the low end of the Fed's perceived comfort zone of 1.5% to 2%. The 10-year inflation rate forecast implied in Treasury inflation-protected bonds (TIPs) yields was a moderate 2.23% at Friday's close.

Financial Markets

· The main force behind the rebound in stock and junk bond prices over the past year was an easy monetary policy. The lesson for investors: "Don't fight the Fed." Fundamentally, the Fed's monetary policy should remain supportive of markets for a few more months, 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 fairly valued 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 14.7 versus a 19 average over the past 21 years.
· Despite their strong advance, stocks will likely outperform Treasury bonds and cash in the year ahead, but the strongest part of the rally - fueled by the easing of monetary policy and the related drop in high-yield bond yields - has very likely already occurred.
· The bond market rally is probably over, but the economic recovery is not likely to be strong enough to push long rates up strongly this year. However, there is some risk that large federal deficits will push up rates more than expected.
· Credit quality bond yield spreads are 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.
· Mortgage rates remain low. 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.

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Economic Outlook

2009

2010

Annual Average

Qtr. 4	Q1	Q2	Q3	Q4	2008	2009	2010
5.9	2	3.8	3.2	3.6	0.4	-2.4	3.2
2.3	1.5	1.4	1.5	1.4	3.3	0.2	1.8
1.6	1.4	1.3	1.4	1.5	2.4	1.5	1.4
3.47	3.72	3.9	4.1	4.25	3.67	3.26	3.99
0.15	0.13	0.15	0.15	0.5	1.98	0.18	0.23
17.32	17.15	18.85	20.25	21	49.51	57.02	77.25
n/a	69.6	36.5	28.3	21.2	-40	15.2	35.5
5.66	5.85	6.05	6.15	6.35	28.38	22.41	24.4
-20.8	-1.8	11.2	15	12.2	2.3	-21	8.9
1083.3	1113	1195	1230	1260	1221.3	944.8	1199.5
18.8	37.8	34	23.5	16.3	-17.3	-22.6	27

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