The Fed’s statement following the December 9 FOMC meeting affirmed that the probabilities of deflation and of inflation are now equal. Kudos! We think it was a masterstroke by the "sky is falling" school of economic policy. First, frighten the wits out of the markets with threats of devastating deflation, subtly avoid showing any evidence of this impending catastrophe, and then at an appropriate time, announce that your anti-deflation weapons have clinched a victory (where was the enemy?).

In recent statements, Mr. Greenspan reiterated his view that the current account deficits and the value of the dollar are irrelevant in a global economy. This marks the beginning of the New New Economy: the Old economy excluding food and energy, and now also excluding the dollar and the trade accounts.

Fed officials have continued to assert that there are no inflationary pressures in the economy. The Wall Street Journal’s (WSJ) survey of economic forecasters agrees with this view by showing lower expected inflation this year with much stronger GDP growth. Based on the CPI (a realistic measure of price level changes) inflation rate of 2.3 percent for 2003, the mainstream forecasters are calling for a CPI of 2.0 percent by November of this year. On the other hand, we think inflation will edge up to about 2.75 percent by the end of this year, and then exceed 3.0 percent in 2005. We are not alone, the University of Michigan’s consumer survey showed inflation expectations of 2.7 percent last November.

One of the explanations given by the Fed for the low inflation rate despite the recent upturn in economy activity is the existence of a high rate of excess capacity in the industrial sector that will allow greater output without generating upward price pressures. We differ with this assessment. Our hypothesis is that much of the so-called excess capacity is actually technologically obsolete and will not be put back into production. Of course someone has to go out there and actually survey the physical plants, "kick the tires," before we can draw any definitive conclusions regarding the availability of excess capacity.

The third quarter GDP figures confirmed that the economy is gathering steam. Industrial production has been posting healthy growth during the past five months. Companies are making plans to hire more workers. Economic forecasts released by the WSJ survey show GDP growth of 4.7 percent this year, we think the economy will grow at a somewhat slower rate of 3.9 percent, but still a healthy showing.

As the U.S. economic expansion continues, the trade deficit will reach higher proportions, despite the recent depreciation of the dollar. We predict the trade deficit will reach 5.6 percent of GDP for this year. The dollar will thus continue to slide, adding to inflationary pressures and eventually pushing up interest rates.

Unfortunately, the current expansion period will be marked by new highs when compared to previous business cycles: the unemployment rate will remain higher than normal, mostly due to the structural imbalances in our economy and to the disequilibrium in our international trade accounts; higher rates of unutilized excess capacity in the economy due to technological obsolescence and increased competition from abroad, meaning the economy will hit the capacity-induced inflation threshold sooner than usual; much higher fiscal deficits; and huge trade deficits. As we have argued in the past, all of these factors will contribute to a rising long end of the yield curve.