The Federal Reserve/Monetary Policy

· At its next policy meeting on Aug. 10, concern about the strength of the recovery and job growth, modest 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, should last at least into the second quarter of 2011.
· The Fed is prepared to ease further if the recovery falters. Options include further emphasizing its low interest rate pledge, encouraging banks to lend by lowering the interest rate paid on idle bank reserves, and purchasing non-traditional assets such as long-term Treasuries and mortgage-backed securities.
· The three nominees for open positions on the seven member Fed Board of Governors came across as inflation doves in a Congressional hearing. (Editorial note: In the long-run, the Fed's main contribution to prosperity and maximum employment is achieving price stability and stable inflation expectations. The Fed cannot buy a lower average unemployment rate with a higher average inflation rate).
· 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 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 unusually weak loan demand (de-leveraging) and bank reluctance to lend due to uncertainty about financial reform legislation and future bank capital requirements.
· Fiscal policy is stimulative with the federal deficit at an unprecedented 10% of GDP this year and last and an expected 9+% in 2011. The federal debt to GDP ratio is rising at a rapid and unsustainable rate.

The Economy/Inflation

· The economic recovery from the Great Recession has turned sluggish and Bernanke said last week that the outlook is unusually uncertain, but aggregate dollar demand (nominal/current dollar GDP) growth is still expected to rise around 4% this year and next vs. -1.3% in 2009. Real GDP should rise about 3% this year and next vs. a -2.4% in 2009. Such rates of real growth would produce only a modest decline in the unemployment rate.
· A double-dip recession is unlikely - a 20% chance. Any double-dip would probably be modest as it would likely spark vigorous quantitative easing by the Fed.
· Underlying inflation has trended lower and inflation is likely to be subdued for some time. Deflation, however, is very unlikely. Inflation expectations have receded. The 10-year inflation rate forecast implied in Treasury inflation-protected bonds (TIPs) yields was 1.75% at Friday's close, down sharply from 2.4% ten weeks ago.

Financial Markets

· The Fed is trying to stimulate growth in aggregate demand (nominal dollar GDP). To do so, it must get the leading economic indicators rising, one of which is the stock market. Therefore, fundamentally, the Fed's monetary policy is bullish for stocks, i.e. negligible short-term interest rates will keep investors seeking higher yields in stocks, bonds, and commodities. Until the Fed lets up on the monetary accelerator (probably not until sometime in 2011), the underlying trend of stock prices is more likely to be up than down - investors will probably be better to go with the flow than "fight the Fed."
· Risk appetites increased further last week, sending stocks higher and reducing 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 appear a little undervalued (oversold) 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 a modest 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.
· Mortgage rates and Aaa corporate bond yields have declined to their lowest levels in over 40 years. Baa corporate yields are the lowest in five-and-a-half years.
· While monetary policy is bullish for stocks in the short-run and stocks appear reasonably valued, the seismic shift in federal economic policy - resulting from the unusual circumstance of an ideological White House being politically aligned with unstoppable majorities in the Senate and House - would not seem to be stock market friendly in the long run.