The Federal Reserve/Monetary Policy

· In the statement following its policy meeting last week, the Fed slightly downgraded its assessment of the economy and added an important phrase saying "...financial conditions have become less supportive of economic growth ...." The Fed has more influence on "financial conditions" than anyone and it decided to support financial markets by continuing to pledge a Fed funds rate <0.25% for an extended period. Increased concern about the strength of the economy, slowing inflation and "less supportive" financial conditions will likely extend the time that the Fed funds rate will be <0.25%. The current 20 month period of <0.25% Fed funds, unprecedented in modern history, appears likely to last at least through the first quarter of 2011.
· As the chances of a double-dip recession have increased, so have the chances the Fed will renew quantitative easing, i.e. Fed special lending facilities to banks and the purchases of non-traditional assets such as mortgage-backed securities.
· Monetary policy appears stimulative based on a negligible Fed funds rate and an unprecedented jump in Federal Reserve credit, however, current dollar aggregate demand growth has slowed from a 6.1% rate in the fourth quarter to 3.9% last quarter and an estimated 3.5% this quarter. Given the economic trauma of 2008 - 2009 plus huge gyrations in monetary/loan data plus uncertainty about financial regulation/reform, there is even more uncertainty than usual about the timing and impact of Fed actions on economic activity. In particular, the transmission of Fed stimulus through bank lending may have been dampened by bank reluctance to lend due to uncertainty about financial reform legislation and future bank capital requirements. Even though a financial reform bill emerged from house/senate negotiators Friday on a vote along strict party lines, considerable uncertainty remains regarding national and international financial regulation.

The Economy/Inflation

· In its Wednesday statement the Fed still said it "... anticipates a gradual return to higher levels of resource utilization.... although the pace of economic recovery is likely to be moderate for a time." Aggregate dollar demand (nominal/current dollar GDP) growth has been lowered slightly but is still expected to rise 3.75%-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 chance of a double-dip recession has increased to 25%. Any double-dip would probably be modest as it would likely spark vigorous quantitative easing by the Fed.
· In its Wednesday statement, the Fed lowered is assessment of recent inflation, saying ".... underlying inflation has trended lower." It continued to say "... inflation is likely to be subdued for some time," but core inflation has been running below the Fed's comfort zone which inclines the Fed to keep monetary policy easy. Inflation expectations have receded. The 10-year inflation rate forecast implied in Treasury inflation-protected bonds (TIPs) yields was 1.96% at Friday's close, down sharply from 2.4% six weeks ago.
· Populist attacks on Wall St. and big business and a sharp shift in healthcare, financial and labor market policies in the past 18 months and prospective policy and tax changes may be retarding growth and job creation. The Business Roundtable, a group of large company CEOs that has been more supportive of current Washington policies than the broader U. S. Chamber of Commerce, published a 54-page report last week listing hundreds of decisions that Washington has taken to hurt the economy. The head of the group said "We see a host of laws, regulations and other policies being enacted that impose a government prescription of how individual industries ought to be structured." He noted "an increasingly hostile environment for investment and job creation..." If, embolden by passage of healthcare and financial regulation, Congress crams through major labor market reform before fall elections change the balance of power , the cost and uncertainty of hiring would rise, depressing long-run job growth and raising the long-run average unemployment rate. Bashing banks, business and employers may be good politics, but it may not be the best way to promote growth/jobs.

Financial Markets

· Just as the economic recovery appears more fragile, investor confidence appears less solid. In a renewed "flight to quality," fund flows have shifted to Treasury and high-grade corporate bonds, depressing their yields, from stocks and lower quality corporate and tax-exempt bonds where yields have stabilized or risen slightly. This has substantially increased bond market credit quality spreads in the past two months, but such spreads are still way below their 2008 crisis peaks (see Bond Market Barometer).
· The yield on the 10-year Treasury bond closed the week at only 3.11% and mortgage rates have declined to their lowest levels in more than 40 years.
· Fundamentally, the Fed's monetary policy should be supportive of stock and bond markets at least through 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. Stocks 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 13.3 versus a 19-average over the past 22 years. Corporate profits are such a high percentage of national income (chart below) that there is a risk earnings will fall short of expectations, especially if the recovery (and corporate top line revenue) weakens and/or wide currency swings and weakness in key export markets depress exports and earnings from abroad.