Volume 7, Issue 20

Volume 8, Issue 7

April 5, 2010

The Federal Reserve/Monetary Policy

·   With core inflation running on the low side of the Fed's presumed target range and the unemployment rate at 9.7%, the Fed is likely to keep the Fed funds rate <0.25% until late this year. However, with the economic expansion eight or nine months old and employment finally rising, there will be increasing debate on when and how the Fed will end its pledge of "exceptionally low levels of the Federal funds rate for an extended period." At its April 27-28 policy meeting, Fed doves will prevail and likely keep the <0.25% funds rate pledge, but there may be some hints about the eventual exit from that pledge.   If not, markets may become more concerned about the Fed's inflation-fighting resolve.
·   Monetary policy appears stimulative based on a negligible Fed funds rate and an unprecedented jump in Federal Reserve credit. Total bank loans outstanding have stabilized in the past four weeks, but are down 8% from a year ago, the steepest drop since the Great Depression. Very rapid money growth in 2008 and 2009 has unwound as more confident investors have shifted dollars from low-yielding bank deposits to bonds, stocks and commodities. Given the economic trauma of the past two years, there is even more uncertainty than usual about the timing and impact of Fed actions on economic activity.
·   The Federal deficit is running a very large 10% of GDP and the deficit outlook is bleak even assuming the large tax increases in the Administration's budget. Federal outlays as a percentage of GDP jumped to 24.7% in fiscal 2009 and are likely to stay about that high in 2010 and 2011 vs. a 20.6% average from 1970 to 2009. Federal interest expense as a percentage of GDP, which was 1.3% in 2009, is expected to be a burdensome 3+% of GDP in 2020 even with big tax increases and optimistic interest rate assumptions. The deficits increase the risk that interest rates will eventually rise, perhaps sharply. If so, intense political pressure would develop to reduce the deficits. The impact of the health care bill will be phased in over time, with the largest impact coming in 2013 when the biggest tax increases occur.
·   Regarding long-run growth, the combination of big Federal deficits, rising marginal tax rates on investment income, and greater government regulation of and intervention in markets, is troubling.

The Economy/Inflation

·   The economic expansion probably started in July 2009 and should endure this year and next. Aggregate dollar demand (nominal/current dollar GDP) should rise 4% this year and 5% in 2011 vs. -1.3% in 2009. Real GDP should rise 3% to 3.5% this year and next vs. a -2.4% in 2009. The recovery is being led by business investment in inventory and equipment, exports, housing and Federal government purchases. Consumer spending will lag and commercial construction will decline sharply.
·   The job growth that finally appeared in March should continue, but some of the Administration's controversial appointments during the Congressional recess will increase employer reluctance to hire.
·   Core consumer inflation-more a lagging economic indicator-is running a little below the Fed's presumed comfort zone of 1.5% to 2%. The 10-year inflation rate forecast implied in Treasury inflation-protected bonds (TIPs) yields was a moderate 2.27% at Friday's close.
·   Oil at $85+ enriches the likes of Iran and Venezuela, while natural gas, mostly domestically produced, is very cheap vs. oil per BTU. Natural gas has proved to be a poor substitute for oil in the short run, but will hopefully provide a larger share of U.S. energy needs in the years ahead.

Financial Markets

·   Fundamentally, the Fed's monetary policy should be 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 15.2 vs. a 19 average over the past 22 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 occurred already. Stock markets obviously embody more risk following the stunning 74% gain in the S&P and the 85% surge in foreign stocks in the last 13 months.
·   Treasury bond yields have increased to their highest levels in nine months. Corporate bond yields have changed little since last summer despite a record issuance of junk bonds. Credit availability has increased dramatically for companies able to access bond markets. Tax-exempt yields have declined some despite state and local government budget problems. The tax-exempt bond market is likely benefiting from the Administration's planned tax increases on dividend and interest income, which increases the value of tax-exempt income.
·   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 moved up a little as the Fed ended its mortgaged-backed security purchases on March 31.

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Economic Outlook

2009

2010

Annual Average

Qtr. 4	Q1	Q2	Q3	Q4	2008	2009	2010
5.6	2.6	3.1	3.4	3.6	0.4	-2.4	3.2
2.5	1.4	1.5	1.5	1.4	3.3	0.2	1.8
1.8	1.3	1.3	1.4	1.5	2.4	1.5	1.4
3.47	3.72	4.05	4.15	4.3	3.67	3.26	4.06
0.15	0.13	0.15	0.15	0.5	1.98	0.18	0.23
17.16	17.17	18.85	20.25	21.1	49.51	56.86	77.37
n/a	69.8	36.5	28.3	23	-40	14.8	36.1
5.66	5.46	6.05	6.15	6.35	28.38	22.41	24.01
-20.8	-8.4	11.2	15	12.2	2.3	-21	7.1
1083.3	1118.1	1215	1245	1275	1221.3	944.8	1213.3
18.8	38.4	36.2	25	17.7	-17.3	-22.6	28.4

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