Volume 7, Issue 20

Volume 8, Issue 12

June 14, 2010

The Federal Reserve/Monetary Policy

· Before Congress last week, Bernanke said the Fed, "will take the actions necessary to ensure stability and continued economic recovery." Doubts about the strength of the recovery and international financial jitters will likely extend the time the Fed funds rate will be <0.25%. At its policy meeting on June 22-23, the Fed will continue its support of the recovery by pledging a low Fed funds rate for an extended period-the Fed funds rate is likely to be <0.25% into, if not through, the first quarter of 2011.   If the recovery appears to be weakening, Bernanke will likely become more vocal (open mouth policy) in pledging whatever Fed support is needed to keep the economy recovering.
· While the Fed is likely to keep the funds rate <0.25% and the European Central Bank and the Bank of England left their policy rates unchanged last week, some central banks have raised rates where growth has been strong or inflation has risen. Examples are Brazil, New Zealand, Australia, India and Canada. The rise in stock prices will likely slow in countries where central banks are tightening monetary policy.    Inflation has accelerated in some important emerging economies such as China and, especially, India.
· 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. Bank loan totals continue to decline, due to weak loan demand and a reluctance to lend given the uncertainty about financial reform legislation.
· Bernanke said last week that the Federal budget is currently "on an unsustainable path." He urged Congress to plan now in order to avoid disruptive future tax and spending policies and to retain the confidence of the public and the markets.   Inaction would eventually "sap the nation's economic vitality, reduce our living standards, and greatly increase the risk of economic and financial instability."

The Economy/Inflation

· Despite weaker-than-expected retail sales and employment reports for May, the 11-month-old economic recovery should endure.   There is less than a 20% chance that the economy will fall back into recession (double-dip), mainly because the Fed will provide whatever support is needed to continue the recovery.    Aggregate dollar demand (nominal/current dollar GDP) is still expected to rise 4% to 4.25% this year and 4.25% to 4.75% 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 and state and local government spending will lag and commercial construction decline sharply.
· Bernanke noted last week a moderation in inflation and stable inflation expectations. Core inflation appears somewhat below the Fed's presumed comfort zone. Modest core consumer price inflation is expected to continue through year end. A rally in the dollar will help keep import prices low. Inflation expectations have receded. The 10-year inflation rate forecast implied in Treasury inflation-protected bonds (TIPs) yields was a 1.98% at Friday's close, down sharply from 2.4% six weeks ago.

Financial Markets

· Risk appetites improved some last week and stocks and the Euro stabilized. Credit quality yield spreads, however, remained sharply above recent lows, but such spreads are still within their historical normal ranges (see Bond Market Barometer).
· Fundamentally, the Fed's monetary policy should be supportive of stock and bond markets at least into the first quarter of 2011, 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. Although a jump in Baa bond yields recently is a negative for stocks, stocks still appear reasonably valued vs. Baa corporate bonds (see 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 13.4 versus a 19-average over the past 22 years. Earnings have recovered strongly and earnings are such a high percentage of national income that there is a risk earnings will fall short of expectations, especially if the recovery weakens and/or wide currency swings and weakness in key export markets depress exports and earnings from abroad.
· Mortgage rates have fallen to record lows 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	3	3.4	3.4	0.4	-2.4	3.3
2.5	1.5	1.4	1.4	1.5	3.3	0.2	1.8
1.8	0.6	1	1.1	1.1	2.4	1.5	1.1
3.47	3.72	3.55	3.55	3.85	3.67	3.26	3.67
0.15	0.13	0.2	0.2	0.2	1.98	0.18	0.18
17.16	19.37	19.5	20.45	21.7	49.51	56.86	81.02
n/a	91.6	41.2	29.6	26.5	-40	14.8	42.5
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	1130	1200	1245	1221.3	944.8	1173.3
18.8	38.4	26.7	20.5	14.9	-17.3	-22.6	24.2

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