Allan Greenspan should be known in history as the "measured" Chairman, or more precisely, the 25 basis points Chairman. His laudable intellectual honesty is better exemplified by his admission that interest rates are a "conundrum". He only had a few missed calls, as when he remarked that the U.S. trade deficit would disappear painlessly and that predicting the value of the dollar is no different than relying on the "toss of a coin". He occasionally exhibited bouts of "irrational exuberance" that simmered only after he sipped his "regional froth", that memorable concoction. that explained how real estate markets would only experience localized, as opposed to national corrections. We will miss his choice of words. In the economics profession and in the corporate boardrooms, few really know more about the nuts and bolts that make up our economy than the highly respected Chairman.

We expect the Fed will raise the Funds rate on January 31, mainly because it will be the last FOMC meeting before Mr. Greenspan’s retirement. Also, we think it would be inappropriate to "steal" from what may be Mr. Bernanke’s thunder. Under the new Chairman’s tutelage, the FOMC will have to decide whether to once again artificially invert the yield curve. Medium- to long-term yields have been stuck at levels we have not seen since the mid-1960s, when the Consumer Price Index (CPI) was averaging only 1.5 percent per annum.

It appears that by maintaining long-term interest rates at their current unusually low levels, markets are now saying that the trendy definition of "core inflation" will remain indefinitely at 2.0 percent and that the dollar will continue to be the strongest currency in the globe. Apparently there is little concern that our external deficits are becoming the black hole of the financial markets.

We think the FOMC will decide not to push the Funds rate this year beyond 5.00 percent, in order to avert an inversion of the yield curve. However, sooner or later, something will trigger an abrupt adjustment in the financial and money markets, and in our view that event will be the fall of the dollar. We expect things to heat up in the currency markets during the second half of this year, and as a consequence, the yield curve will begin to steepen with the 20 year bond climbing to 5.5 percent by year end.

Once upon a time, economists would define inflation as the percent change in the CPI, and they explained how the rate varied according to cyclical factors. Now many subscribe to the "core inflation" concept. Since it excludes items that exhibit greater than usual volatility, such as food and energy, "core inflation" is a very stable price index. On the other hand, our measure of inflation, which is based on a moving average of the CPI index, should peak in February of this year at 3.5 percent and will remain in the 3.0 - 3.5 percent range during the next one to two years. The latest University of Michigan consumer survey shows inflation expectations of 3.3 percent. Curiously, we think the "core" rate of inflation could begin to exceed the un-trended CPI rate later this year, so perhaps it will be time to come up with a new measure of inflation. With labor costs still under control, we think "demand pull" factors will continue to drive our inflation rate but at a more moderate pace followed by a rise in the cost of material inputs.

After a strong third quarter with GDP growth of 4.1 percent, we think the fourth quarter will cool off to 2.9 percent. Industrial production has been recovering since September 2005's strike by Hurricane Katrina. But by December, output was expanding at a lackluster 12 month rate of 2.8 percent, down from a rate of 4.4 percent in December 2004. We think that consumer spending has slowed noticeably in the fourth quarter, as very high energy prices have reduced purchasing power. Retailers experienced mixed results during the Holiday season. December retail sales were up 6.4 percent, slower than the 8.7 percent expansion in December 2004. The recent dip in home refinancing also means that consumers have been less willing to cash out some of their homes’ net worth for additional spending. For instance, the index of home remodeling was down 5.6 percent in November, compared to the same period in the previous year. Nevertheless, continued growth in business investment will help to sustain the economic expansion.

We expect average GDP growth of 3.1 percent in 2006, which is lower than the WSJ’s survey of economists that calls for 3.5 percent. Real estate is the wild card, particularly as the long-end of the yield spectrum starts to move up in the second half of this year. Recent data shows that the housing market peaked in mid-2005. There is an air of caution in the building industry after the slowdown that began in the fourth quarter. Another telltale sign, bank regulators are beginning to warn of risks in real estate lending.

We are still closely monitoring currency market developments for the timing of our expected downward correction in the value of the dollar. As we have explained in our recent Briefings, a U.S. current account deficit, which we project to reach 7.0 percent of GDP this year, is alarming. When an external deficit of such magnitude combines with the recent upward trend in inflation, it will most likely trigger a downward spiral in the value of the dollar against the other major currencies. The likelihood of a change in the U.S. political climate, following this November’s congressional elections, could be another trigger point. The new Congress could adopt a hard-line position regarding China’s bulging trade surplus and impose higher tariffs or other restrictions against Chinese products. In our view, such measures could precipitate a sharp downward adjustment in the value of the dollar. With respect to the timing of a dollar correction, we think markets will act sooner rather than later.

GDP growth for the region declined moderately to 4.3 percent from 5.6 percent in the previous year. Only marginal improvement in inflation was achieved last year, due to higher commodity prices, particularly oil prices.

In 2006 another nine countries will elect a new president, Brazil, Colombia, Costa Rica, Ecuador, El Salvador, Mexico, Nicaragua, Peru, and Venezuela. President Lula’s chances for an easy victory in Brazil have been thwarted by a corruption scandal in his party. Colombian president Alvaro Uribe should win reelection, based on his widespread popularity. Nobel Prize winner and former president, Oscar Arias, seems assured of winning the contest in Costa Rica. He is of center-right and supports market-oriented policies. Political fragmentation is still plaguing Ecuador without clear candidates. Mexico seems leaning toward leftist Andres M. Lopez Obrador. Nicaraguan politics have been muddled by scandals and dirty tricks. In Peru, center-right politician Lourdes Flores is being seriously challenged by Ollanta Humala, a mixture of indigenous activist a la Evo Morales and a failed military coup leader a la Hugo Chavez. And President Hugo Chavez will do anything to cling to power.