Volume 7, Issue 20

Volume 8, Issue 10

May 17, 2010

The Federal Reserve/Monetary Policy

· At the Fed's next policy meeting on June 22-23, the debate will continue on when and how to exit from the Fed's pledge of a low Federal funds rate for an extended period. The stronger the economic data over the next five weeks, especially May's jobs report on June 4, the more intense the debate. While there is a chance the Fed will cautiously soften its pledge, the Fed will most likely continue its pledge based on a high unemployment rate, subdued inflation, increased financial market volatility and international financial market turmoil. Indeed, the Fed last Sunday showed its willingness to temporarily expand its balance sheet and the supply of $s by re-establishing $ lines of credit to European Central Banks. The Fed funds rate is likely to be 0.25% through year end. In the meantime, the Fed is prudently conducting a small scale test of its plan to drain reserves from the banking system when it deems the time is right.
· Monetary policy appears stimulative based on a negligible Fed funds rate and an unprecedented jump in Federal Reserve credit, but, given the economic trauma of 2008 and 2009 and huge gyrations in monetary/loan data, there is more uncertainty than usual about the timing and impact of Fed actions on economic activity.
· Even with the economy recovering moderately, the Federal deficit is still running a very large 9+% of GDP and the deficit is likely to be a very significant % of GDP in coming years even assuming the large tax increases in the Administration's budget. Hopefully, Europe's sobering financial problems and Bernanke's warnings about the unsustainable path of current U.S. fiscal policy will not be "Greek" to our politicians. However, a number of U.S. political/economic trends are reminiscent of much of Europe and low interest rates are relieving current pressure to address our longer-run fiscal problem.
The

Economy/Inflation

· The 10-month-old economic recovery looks sustainable and job growth has picked up. Aggregate dollar demand (nominal/current dollar GDP) should rise 4% to 4.5% this year and 4.5% to 5% in 2011 vs. -1.3% in 2009. Real GDP should rise 3.25% to 3.5% this year and next vs. a -2.4% in 2009. The recovery will be led by business investment in inventory and equipment, exports, housing and Federal government purchases. Consumer and state and local government spending will lag and commercial construction decline sharply.
· Core consumer price inflation is expected to continue to be below the Fed's presumed comfort zone through yearend. Unit labor costs in the nonfarm business sector declined at a 1.6% rate in the first quarter and were down a sharp 3.7% yr/yr. Commodity price indexes dropped sharply in the past two weeks and indexes are at the same level they were nine months ago. The dollar has rallied in currency markets, especially vs. the Euro which is down 18% vs. the dollar since the Euro's October peak. The 10-year inflation rate forecast implied in Treasury inflation-protected bonds (TIPs) yields was a 2.23% at Friday's close, down from 2.4% two weeks ago. In the rapidly growing economies of Asia, inflation is picking up.

Financial Markets

· European financial turmoil has caused investors to flee stock and corporate bond markets and buy U.S. Treasury bonds. Gold and the dollar have also benefited from this "flight to quality" demand. While credit quality yield spreads increased in the past week, they are still within their historical normal range (Bond Market Barometer).
· While the stock and high-yield corporate bond markets obviously embodied more risk following their strong rallies in 2009 and 2010, recent drops in corporate stock and bond prices are probably not the beginning of prolonged or severe downturns.
· Fundamentally, the Fed's monetary policy should be supportive of stock and bond markets at least through yearend, 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 (a leading indicator) strength. The yields on both the S&P 500 and Baa corporate bonds have risen, leaving stocks 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 14.2 versus a 19 average over the past 22 years. Earnings have recovered so strongly that there is a risk earnings will fall short of expectations later in the year, especially if the recovery stalls and/or wide currency swings and weakness in key export markets depress exports and earnings from abroad.
· During the 14 month stock market rally, it seems that when confidence has been lost and stocks have dropped, commodity prices and bond yields have quickly dropped in turn which has soon revived the stock market. This same cycle may be about to occur again.
· Mortgage rates have fallen back to their lowest levels of 2010 even though the Fed stopped buying additional mortgage-backed securities on March 31.

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Economic Outlook

2009

2010

Annual Average

Qtr. 4	Q1	Q2	Q3	Q4	2008	2009	2010
5.6	3.2	3.4	3.4	3.6	0.4	-2.4	3.3
2.5	1.5	1.4	1.5	1.5	3.3	0.2	1.8
1.8	0.6	1.2	1.3	1.3	2.4	1.5	1.2
3.47	3.72	3.85	4	4.2	3.67	3.26	3.94
0.15	0.13	0.17	0.17	0.17	1.98	0.18	0.16
17.16	19.12	19.35	20.3	21.45	49.51	56.86	80.22
n/a	89.1	40.1	28.6	25	-40	14.8	41.1
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	1180	1235	1270	1221.3	944.8	1200.8
18.8	38.4	32.3	24	17.2	-17.3	-22.6	27.1

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