Last year Mr. B referred to the transition phase in the U.S. economy marked by a slowdown in growth which could eventually cool off inflationary pressures. At the same time he warned that there are still substantial uncertainties regarding the expected rate of inflation. Mr. B’s open management style has also allowed other Fed officials to express their views on these economic issues, thus shedding greater light on the likely course of economic policy than the "coded messages" sometimes used by previous Fed Chairmen. Recent attempts by legislators to lure Mr. B into testifying at length on fiscal policy, in view of the Administration’s leadership gap in this area, were met by Mr. B with measured but discreet responses in order to avoid being out of compliance with Fed policy.

Core Economics appears to be gaining ground in the mainstream of the profession. Analysts are increasingly making the distinction between"core" and "headline" economics. By selectively excluding data and information from the analysis, the practitioner of "core" economics can establish trends which coincide with the analysts’ views. For example, in a recent financial media report on durable goods orders, the analyst pointed out that orders for "core" capital goods, "excluding defense and aircraft" showed consistent growth. The term "headline" economics appears to be applied to the methodology of utilizing statistical and economic tools to analyze all components of the data such as the use of moving averages to weed out month-to-month volatility in the CPI inflation index. The message seems to be skip the "Headline" go to the "core" analysis.

Economic activity continues to weaken, although some pickup is anticipated during the second half of this year. This is in line with the Fed’s view of an economy in a transition phase. During the second and third quarters GDP growth slowed to 2.6 percent and 2.0 percent respectively, due in part to sizeable consecutive drops in residential investment of 11.1 percent and 18.7 percent. The correction in the housing market, which appears to be more than just a "froth," aggravated the slowing trend in the economy which appears to have started at the end of 2004. After a peak of 3.9 percent growth in 2004, the economy posted a modestly slower rate of 3.2 percent in 2005. Another factor explaining the gradual deceleration of the economic engine has been the rising trade deficit as U.S. businesses and consumers become more reliant on imported goods and services. Recent data shows that industrial production, a key barometer of output growth, has been losing some steam since the end of last summer, following the surge in oil prices. We expect GDP growth to slow to 2.5 percent this year after 3.3 percent in 2006.

The good news is that inflation – based on our moving average CPI measure, has been trending down since the end of last summer, although that trend varies depending on the period of comparison. Last year’s annual average inflation of 3.2 percent was marginally below the 3.4 percent posted in 2005, and our projections show a rate of 2.3 percent for this year, helped by the recent drop in oil prices. However, if we measure inflation on a December to December basis, our inflation forecast for this year shows 3.8 percent up from 2.5 percent in 2006, which reflects our view that inflationary pressures will resume during the second half of this year, but at a moderate pace. For a different perspective, the University of Michigan consumer survey shows that inflation expectations have actually declined from 3.8 percent in August of last year to 2.9 percent in December. These differing views on inflation underscore the Fed’s concerns about future uncertainties. In fact the consumer inflation expectations index has shown greater volatility during the past 18 months.

With respect to interest rate "conundrum," the Fed’s reference to a lower term-premium appears to be a reasonable explanation for the unusual shape fo the yield curve. Another factor that has played into this analysis has been the view that global liquidity has been growing at a brisk pace. However, this could be a recipe for higher inflation, which could then trigger a sharp increase in the long end of the yield spectrum. We think that the 10 and 20 year Treasuries will trade in narrow range through the first half of this year, and if inflationary pressures fail to subside and the economy shows greater than expected resilience, then the yield on the Treasury bonds could begin to edge up during the second half of the year.

Both the fiscal and the external deficits are expected to improve this year. Thanks to stronger growth in revenues, the FY2007 budget deficit is now expected to be lower than initial projections. The CBO predicts a deficit, measured on a cash basis, of $172 billion, down from $248 billion in FY2006. On an accruals basis the deficit figure would be much higher.

On the external front, continued growth of exports is also contributing to a lower deficit for 2006 than we had projected at the beginning of the year. Our initial forecast back in last January had been for a trade deficit of $900 billion, but based on January-November figures, we estimate the deficit will only reach $850 billion. With the Fed holding off on lowering short-term interest rates, and with the trade deficit apparently leveling off, for now at least, we could see some temporary relief for the dollar in the currency markets.

Latin American Economies

Preliminary CEPAL (UN Economic Commission for Latin America) estimates for 2006 for the Latin American region show continued strengthening of the external sector. The trade surplus grew to an estimated $82.3 billion in 2006, up from US$63.3 billion in 2005. The current account surplus expanded from $35.9 billion in 2005 to $51.3 million in 2006, relative to regional GDP, the surplus rose from 1.5 percent in 2005 to 1.8 percent in 2006. The external debt figures have also improved from $656.1 billion in 2005 to $632.8 in 2006.

                                    Latin American Economies

                  Preliminary Selected Economic Indicators 2006

Source: CEPAL and StratInfo (average inflation figures)