The Federal Reserve/Monetary Policy

· At its next policy meeting on August 10, concern about the strength of the recovery and job growth, slowing inflation and some ongoing restraint in credit availability will incline the Fed to keep the Fed funds rate <0.25% "for an extended period." 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.
· The Fed will resort to quantitative easing - Fed special lending facilities to banks and purchases of non-traditional assets such as mortgage-backed securities - only if the recovery falters significantly and a double-dip recession appears likely.
· 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 been sluggish. Given the economic trauma of 2008 and 20099 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 unusually weak loan demand and bank reluctance to lend due to uncertainty about financial reform legislation and future bank capital requirements.

The Economy/Inflation

· The economic recovery has been sluggish, especially given the depth of the 2008 and 2009 Great Recession. The outlook for aggregate dollar demand (nominal/current dollar GDP) growth and for real GDP growth have been lowered slightly, but aggregate demand is still expected to rise around 4% this year and next vs. -1.3% in 2009. Real GDP should rise 2.75% to 3% this year and 2.5% to 3% in 2011 vs. a -2.4% in 2009. Such rates of real growth would not be enough to generate big job gains.
· A double-dip recession is unlikely - a 25% chance. Any double-dip would probably be modest as it would likely spark vigorous quantitative easing by the Fed.
· Although commodity prices jumped along with stocks last week, underlying inflation has trended lower and inflation is likely to be subdued for some time. Inflation expectations have receded. The 10-year inflation rate forecast implied in Treasury inflation-protected bonds (TIPs) yields was 1.81% at Friday's close, down sharply from 2.4% eight weeks ago.

Financial Markets

· Fundamentally, the Fed's monetary policy should be bullish for 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. Eventually the Fed will join many foreign central banks - such as South Korea last week-in raising rates, but, until then, it will probably be better to go with the flow than "fight the Fed."
· The financial market "flight to quality" reversed last week, sending stocks higher and stabilizing bond market credit quality yield spreads, though such spreads remain significantly higher than two months ago (see Bond Market Barometer). On the other hand, such spreads are far below the crisis peaks reached in late 2008.
· Stocks got moderately undervalued (oversold) vs. Baa corporate bonds by Friday, July 2. Last week's rebound in stocks (decline in the S&P 500 dividend yield) and rise in the Baa yield still leaves stocks undervalued vs. Baa corporates, but considerably less so that on July 2 (see Stock Market Barometer).
· Sustaining the economic recovery will likely require stock market (a leading indicator) strength. 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 vs. a 19 average over the past 22 years. Corporate profits are such a high percentage of national income 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. Also, seasonal forces may constrain stocks since the third quarter is historically the weakest of the year for stocks (the fourth quarter is historically the strongest quarter of the year).
· Mortgage rates have declined to their lowest levels in over 40 years.