Notwithstanding our critical view of some of the Fed’s actions, Mr. Greenspan does have a keen eye for the details beneath the details, and probably knows more about Wall Street than the Fortune 100, since in his previous professional life he was their economic advisor. We think the Fed Chairman has flagged a critical issue in the financial markets. His concerns about Fannie Mae and Freddie Mac are very well placed. In the U.S. financial system, supposedly the bastion of free markets, the government has nurtured a quasi public financial intermediary to earn a huge return for its shareholders. This amazing feat of financial arbitrage is simply based on the use by these "agencies" of an unconditional government guarantee on all of their liabilities. Of course taxpayers are the ones who will pay all the bills in the event of a systemic asset quality problem that could be triggered by higher interest rates combined with a real estate market downturn. The Fed Chairman has recommended placing a limit on their portfolio of assets. While we agree with this assessment, implementing such a policy will adversely affect the supply of mortgage financing and consequently its cost to consumers.

The economy continues to expand at a healthy pace. Fed officials believe the economy will remain on a path of solid growth. The mainstream forecast based on the WSJ survey of economists calls for GDP growth of 3.8 percent this year, down from 4.4 percent in 2004. We project a moderately lower rate of 3.5 percent, due to higher energy prices, higher inflation, a much weaker dollar, and higher interest rates. Industrial production is currently growing at an annual rate of 4.0 percent. Retail sales, adjusted for inflation, have kept up their momentum during the first quarter of this year. The downside to the robust growth in consumer spending is that consumer debt continues to rise thus increasing their vulnerability to higher interest rates.

We are intrigued by market analysts’ collective sigh of relief that the economy has not plunged into recession with oil prices breaking through the $54 per barrel mark. The consensus view seems to be that the surge in oil prices has had only a limited impact on the economy, with some analysts explaining how ample liquidity in the economy arising from the Fed’s accommodative policies have helped keep the economy on a roll despite the surge in oil prices. This sends a cold chill down our spines, since as we have explained in past StratAlerts, excess liquidity pumped into the economy in order to bring down interest rates will eventually fuel higher inflation. Further weakening of the dollar will contribute to more inflation, particularly when the Chinese revalue the yuan, which could be as much as 40 percent.

As we have predicted, inflation is accelerating. Our moving average measure of CPI inflation was 3.0 percent in March. We have revised our forecast to 3.4 percent by the end of this year. The mainstream forecast based on the WSJ survey of economists shows an optimistic 12 month inflation rate of 2.5 percent for November this year, which implies a noticeable decline in inflation during the next several months. On the other hand, the University of Michigan consumer survey, which is closer to our own forecast, shows expected inflation of 3.2 percent based on the March survey.

The twin deficits, trade and fiscal, continue to threaten the economic expansion. As of February, the cumulative 12 months trade deficit stood at $693 billion, and we are predicting a deficit of $785 billion for 2005, or 6.3 percent of GDP. The CBO forecast of the fiscal deficit for 2005 is 3.0 percent of GDP, and trending down through the end of this decade. Since policy makers consider the balance of payments deficit irrelevant, no one has been asked to project the magnitude of this deficit through the end of the decade in order to assess the viability of its financing by foreign investors. We welcome U.S. Treasury involvement in such an initiative. We think a projection of the external deficit will overwhelm the projected figures for the fiscal deficit. One of the reasons why the depreciation of the dollar has not resulted in a reduction of the external deficit is that the deficit is a symptom of underlying structural imbalances in the U.S. economy. For that reason, the dollar will have to depreciate much more in order to trigger a positive response in the balance of payments. And continuing trade imbalances in the medium- to long-term will result in greater currency market volatility.