The Fed lifted the Funds rate to 2.25 percent at this month’s FOMC meeting. The question now is what will they do in the New Year? While monotony is the Utopia of Central Bankers, we think they will add some spice to their tap dancing in order to keep the markets a little more intrigued about such delectable monetary policy insights as to how many times did Chairman Greenspan scratch his head during the FOMC meetings. Anyway, we think they may skip some steps in 2005, and perhaps change the pattern of the stepwise increase, but by year end 2005 the Funds rate could be in the3.50 to 3.75 percent range. This would be consistent with a shift in policy from the current accommodative to a modestly anti-inflationary stance, particularly in view of the fact that the economy just keeps on going despite higher inflationary pressures.

Inflation is gathering momentum

The Fed and others will probably not recognize that we were right about inflation – we are just a tiny economic and financial consulting firm from Miami. However, more Fed officials are recognizing that inflationary pressures are building. But, the rumblings in the usually silent halls of monetary policy indicate that a new definition of inflation will soon be making headlines in the financial media: the PPI – the Pure Price Index. After intensive and meticulous research, analysts have concluded that almost all prices are volatile, thus the new PPI inflation index will exclude all goods and services showing any price increases. This will undoubtedly show that inflation is indeed "quite modest." At which point the long end of the yield curve will descend to the bottom of the scale. Our modest and simplistic CPI index, based on a 12 month moving average of all items in the basket shows an annual inflation rate of 2.8 percent by December. The University of Michigan’s consumer survey shows inflation expectations of 2.8 percent in September. Interestingly, consumers appear to subscribe to the traditional definition of inflation.

Economic activity has continued to improve with only a modest impact from higher oil prices. Based on the third quarter GDP growth of 4.0 percent, we expect GDP growth of 4.4 percent for this year – on a year average basis, and slower growth of 3.1 percent in 2005. Industrial production is doing very well with the 12 month growth rate at 5.2 percent in October. The real estate sector, particularly residential, is still benefiting from very low mortgage rates.

Our outlook for 2005 calls for lower but still healthy growth of 3.1 percent accompanied by higher inflation of 3.5 percent. The Christmas tree of economic indicators shows a merry picture. Consumer sentiment has been moving up moderately. Employment growth continues but it is more noticeable in the services sector. Profits are growing but at a slower pace, impacted by higher prices for raw materials. Higher inflation is now starting to shake the tree. The recent slowdown in productivity growth, which we have been expecting, will make the increases in prices more pronounced.

We hit right on the nose our August forecast for the US dollar / Euro rate. On December 12, the rate hit US$1.3437 / €. We had been predicting US$ 1.35 / € by the end of the year. We are intrigued by the Fed Chairman’s repeated remark that "forecasting exchange rates is no better than a coin toss." If he is consistent, then he would have to acknowledge that the same reasoning would apply to the FOMC’s management of monetary policy. We think the Euro will continue to rise during the first half of next year. Also as we had predicted, the trade deficit is likely to hit $640 billion this year, or about 5.6 percent of GDP. The financial media has recently been excited by a new pro-dollar trend: oil exporting countries buying up US government securities. However, we call this phenomenon, "parking your dollars," before they begin to adjust their portfolio and send the dollar on a tailspin. Linking the dollar’s devaluation to inflation, we think US producers are now going to be able to raise their prices without worrying about foreign competition, due to the much lower value of the dollar.

Of some concern now are trade relations between the US and China. The Chinese trade surplus continues to mount. Yet if the value of the yuan were a market determined factor, the sizeable trade surpluses would result in an appreciation in the value of that currency. We think the Chinese government is holding to its undervalued currency in order to maximize export sales, among other goals. On the other hand, US political interests are heating up and looking to raise the stakes in the battle of the currencies. We think the Chinese government will hold out until it interprets a threatening US position as an ultimatum, and then allow market forces do their job in lifting the value of the yuan.

On the other side of the Atlantic, European governments will be voicing their displeasure with the weakening dollar and will be hounding Washington to stop the dollar’s slide. Some sparks will also fly from these conversations. In the meantime, the US trade deficit continues to bulge.