There is a growing murmur of interest in the notion that the Fed should put its money where its mouth is by targeting inflation. Under this arrangement, the Fed would periodically announce an inflation rate target and then use its monetary policy instruments to achieve that target. We think there are two problems with this proposal. First, what inflation rate is the Fed going to target? The CPI, the CPI ex-food and energy, the Personal Consumption Expenditures Deflator (PCE), the PCE ex-food and energy, or any other variant? What if the Fed subsequently changes the definition of its preferred measure of inflation and the new measure happens to show that they have achieved their target, will they have achieved the goal of controlling inflation? Second, it is much easier to control the Funds rate, which is dictated by the FOMC, than to manipulate financial variables in the hope that they would result in an expected inflation rate.

In his latest Congressional Testimony (February 16), Mr. Greenspan asserts that the US economic expansion is on a firm path, that inflation has subsided and that core inflation will remain low. But the rest of his testimony seems to question his opening salvo. He goes on to say that productivity growth has slowed, and that it is "notoriously difficult" to predict future growth in productivity. He is also concerned about the recent "quickened pace" of increases in import prices. To further cloud the picture he goes on to say that "bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience." But as not to disquiet the usually hyper Wall street markets, the Chairman concludes with the comment that "Although the long-run challenges confronting the U.S. economy are significant, I fully anticipate that they will ultimately be met and resolved." (Perhaps there will be a Gone with the Economy sequel.)

We do agree with the notion that the long-end of the yield curve is a conundrum. As we have explained in previous StratAlerts, one reason could be a lack of consensus as to what inflation is: the CPI, CPI ex-F&E, PCE, PCE ex-F&E, GDP deflator...? Since long-term interest rates are determined by inflation expectations plus a real interest rate factor, and since the popularity of New-Age Inflation rate definitions is a relatively recent phenomenon, markets are not yet focused on a common view of inflation. Interestingly the inflation-indexed Treasuries use the CPI, and analysts have then applied the average spread over inflation established in the market for these instruments to analyze nominal bond rates incorporating their notion of the New-Age Inflation index, clearly a confusing scenario.

The foregoing considerations lead us to the following conclusions: first, the Fed will continue to increase the Funds rate to about 3.75 percent by year end, which implies no rate changes during the summer meetings of the FOMC. Second, the long-end of the yield curve, the 10 and 20 year yields, will start to move up later in the year, possibly reaching 5.50 percent and 6.25 percent by end of December.

We think the yield curve will continue to flatten in the near term and then begin to shift up during the second half of the year as inflationary pressures become more apparent to the financial markets. We expect inflation to average about 3.0 percent this year. Once again, consumer inflation expectations, as surveyed by the University of Michigan, held steady at 3.0 percent in December. But then mainstream economists are predicting that inflation will actually decline to 2.3 percent by November of this year. We think the markets are going to exclaim "Look Ma, Inflation!" in the not too distant future. Non-farm business productivity is slowing down noticeably, and accordingly unit labor costs have started to pick up. The economy will continue to expand, giving producers a reason to raise prices. We predict GDP growth of 3.2 percent this year, versus 3.6 percent as predicted by the WSJ survey of mainstream economists.

Let’s not forget our longstanding tirade about the out-of-control trade deficits and the continuing decline of the dollar, which will translate into higher inflation and further increases in interest rates. We expect the trade deficit to reach new peaks this year, until the Euro reaches our predicted value. Our expectation of further declines in the value of the dollar is based on what is referred to as "over-shooting" in the currency market: since the US economy does not seem to respond to the lower value of the dollar, the market then pulls down the value of the dollar way beyond the "equilibrium" value in order to get the economy to respond. How does this translate into inflation? Well imported goods become more expensive AND domestically-produced import competing firms also raise prices. The phenomenon of imported inflation also creeps through the production cycle. Analysts point to strong productivity growth in US manufacturing, and we point to outsourcing of production. In other words, as more production is shifting to lower cost offshore sites, the assembly of the final product in the US uses the more capital intensive process for which labor productivity is much higher. The bottom line is that as the dollar depreciates in value, the imported components will become more expensive, thus adding to cost push inflation.