Our call for the May 4 FOMC meeting is that the Fed will keep the Funds rate at 1.00 percent. However, our intelligence sources are now revealing a surge in market chatter that indicates the possibility that the Fed will raise the Funds rate at the August 10 meeting rather than after the elections. This is in line with our view that rates have no other way to go but up. Remember the Fed claims it has already slain the deflation dragon, but was this dragon real or imaginary?

In a recent statement, Mr. Greenspan alluded to short-term interest rates as being at 0 percent in real, or inflation adjusted terms. This means that inflation expectations should be 1.0 percent. As of March, the inflation rate was at 2.0 percent, which translates into a negative real interest rate. Of course, the personal consumption deflator, which is the Fed’s measure of inflation, shows a lower figure, but still above one percent. Rather than a deflator we prefer to use actual prices to measure inflation. More importantly, in March, consumer inflation expectations, as measured by the University of Michigan survey, were at 2.9 percent. We also prefer to gauge expectations based on individuals who actually go to the supermarket and open up their pocketbooks to pay for their purchases. Interestingly, our inflation forecast for the end of this year is 2.9 percent (based on our moving average model of the CPI).

The long end of the yield curve has started to ascend once again. We continue to see the 20 year Treasury Bond at 6.5 percent by the middle of 2005. This is based on our simple-minded model which adds expected inflation of 3.00 percent and the historical average real interest rate of 3.50 percent. If we were to factor in the huge fiscal and trade deficits we would have to adjust the real interest rate factor to 4.0 percent or higher, with the consequent upward adjustment to the long end of the yield curve.

The track record of rates during the past business cycle offers some interesting contrasts. Going into the 1990-91 recession, inflation was high and the yield curve was also negatively sloped. With the subsequent expansion inflation began to decelerate gradually, supporting lower long-term rates, while the real interest rate factor remained in the 3.0 - 4.0 percent range. With the steep fall in oil prices in 1998, as the average price of oil fell to $11.28 per barrel in December of that year, inflation began to dissipate to new lows and the real interest rate factor moved in parallel. As the economy entered the 2001 recession, inflation was on its way down, and the Fed engineered a very steep yield curve, but with historically low real interest rates. The question now is what will happen when markets become impatient at seeing a rising inflation rate? How high will the yield curve move and how steep will it have to become before the Fed becomes a little less patient?

The economic expansion continues at a healthy pace; however, many analysts insist on applying linear vision with respect to the relationship between economic growth and the unemployment rate. As we have said on numerous occasions, fundamental structural changes in our economy have had a material impact on that relationship, and as a result, the (structural) unemployment rate will remain high despite a healthy growth in disposable income, this will thus translate into some additional concentration in our income distribution.

Analysts have also been discounting the risk of inflation because according to the Fed there is ample excess capacity in the economy. However, we are perplexed by the lack of understanding concerning the relationship between technological innovations, productivity, and capacity utilization. We think there is a need for greater focus on the concept of structural economic change. If there is a surge in technological innovation, there will be a corresponding change in what economists refer to as the production function. We think the Fed should take the time to inspect some of those industrial plants that are supposed to represent idle capacity. If we were to walk inside one of those plants would we find the latest computers linked to sophisticated production machinery waiting for a plant engineer to turn on the production line, or would we find old corrosive machines with obsolete production technology which is just waiting for a bid from a dealer in scrap metal? We should be better informed before jumping to conclusions.