We expect the FOMC to raise the Funds rate by a quarter point to 1.50 percent at its August 10 meeting. We think the Fed will continue to raise the Funds rate in subsequent meetings with the possibility that some of those increases will be as high as 50 basis points. Our interpretation of raising rates at a "measured pace" is that the Fed will raise the Funds rate in even steps each meeting, as part of their strategy to make their actions more closely correlate with their statements regarding monetary policy; although we expect one or more of those increases will be as high as 50 basis points as inflation is likely to turn up again. At the conclusion of its last FOMC meeting, the Fed issued a warning, that it will raise rates at a "pronounced and unpredictable" (our characterization) pace if needed in order to "fulfill its obligation to maintain price stability" (from the text of the June FOMC statement). However, there is a fundamental difference between the Fed and our views regarding inflation. The Fed is adamant that inflation is a temporary phenomenon and that in the long-term it is a very small number, 1.0 - 1.5 percent, based on their so-called "core" measure of inflation. We on the other hand think that inflation is accelerating moderately, based on the moving average CPI, and that it will reach 3.3 percent by the end of this year – currently it is at 2.2 percent.

We have been right about inflationary trends, while the Fed has had to acknowledge that even by their own measure, inflation exceeded their expectations during the first half of this year, a trend we think will continue into the second half of the year. Even consumers, whose views policy makers do seem to rely on, maintain their inflation expectations at 3.3 percent as reported by the University of Michigan’s consumer survey. Inflationary pressures can build up over time, sometimes triggered by price shocks such as energy prices (as in the 1970s). Actually, the acceleration in inflation may not materialize instantly. There could be a lag between the time of the price shock and its effect on prices. We think we are nearing this critical point, although the resulting inflation this time will be moderate by historical standards. However, the Fed’s view is that inflation is simply a temporary phenomenon. In fact, we may be in the minority, since the latest Wall Street Survey of leading forecasters shows their CPI expectations as 2.9 percent for November 2004, and 2.2 percent for May 2005, in other words, declining inflation.

A New Theory of Inflation

The July 20 Testimony by Fed Chairman Alan Greenspan before the Banking Committee of the Senate on the occasion of the semiannual Monetary Policy Report to Congress was an eye opener. Incessant in its quest for another explanation for low inflation, the Fed officially introduced the profits theory of inflation. According to Mr. Greenspan’s testimony, "all of the 1.1 percent increase in the prices of final goods and services produced in the nonfinancial corporate sector [during 2003] can be attributed to a rise in profit margins." The Chairman makes this sweeping statement without reference to specific sectors that are benefitting from unusually high profitability. Considering that most economic textbooks explain inflation by two factors: demand-pull and cost-push, the profits margin theory is imaginative, convoluted, and academic. Of course, one could derive from the Chairman’s statement concerning higher profits margins, that because demand in the economy is growing at a healthy pace, prices are consequently rising (demand-pull theory) and as a result, so are profit margins. Thus, Mr. Greenspan’s statements could be interpreted as demand-pull inflation in disguise, but his analysis does not end here.

The clever design of the Fed’s profit margin theory is made evident when seen as part of their constant quest for a theory that there is no inflation. Mr. Greenspan’s testimony goes on to say that "any tendency for profit margins to continue to rise is countered largely by the entry of new competitors willing to undercut prices." Therefore, inflation would only last temporarily. This is an ingenious use of economic gimmickry. Profits drive inflation, but competition drives down profits, and thus inflation. Unfortunately we have several fundamental problems with this new theory. First, the Fed is applying a long-term economic phenomenon to explain short-term trends in inflation. Economic theory says that if a market is characterized as perfectly competitive, then in the long-run, profits would go to zero. In the meantime inflation may rise above trend and interest rates rise beyond market expectations. Second, the theory assumes all industries are the same. However, there are different types of market structures such as monopoly, monopolistic competition, and oligopoly, which would counter the Fed’s price cutting competitive environment. Third, "demand-pull inflation" (as taught in economic textbooks) can be followed by "cost-push inflation" (ibid) thus compounding the rise in prices. For example, the recent strike in the steel industry (usually considered an oligopoly), could result in rising labor costs, and thus higher prices. What will the Fed think of next?

Economy continues to grow

The expansion has gathered some steam this year. Second quarter GDP growth was revised down to a still respectable 3.9 percent. Consumer spending on motor vehicles and parts fell 17.2 percent during the first quarter. On a positive note, business investment on equipment and software continued to sail ahead, while investment in residential construction slowed further. We think GDP growth will be modestly lower in the second quarter. Recent data on industrial production and retail sales shows the economy may be losing some steam. We expect GDP growth of 3.6 percent this year, based on fourth quarter to fourth quarter basis, and then a slowing to 3.0 percent in 2005 as a result of higher inflation, higher interest rates, a weaker dollar, and concerns over the unsustainability of structural deficits. The WSJ survey of leading forecasters shows GDP growth of 4.3 percent for this year, followed by 4.1 percent for the first half of 2005 (the survey does not cover the full year). The Fed’s July forecast calls for GDP growth of 4.5 - 4.75 percent for this year, followed by 3.75 - 4.0 percent in 2005.

The key question is by how much will the Fed raise the Funds rate and by when, and what will happen to the long end of the yield curve. We think the Fed will continue to raise the Funds rate in accordance to their "obligation to maintain price stability." This means that the FOMC could push the Funds rate up to 2.00 – 2.25 percent by the end of December. As inflation accelerates, the Funds rate could be in the range of 3.50 - 3.75 percent by the end of next year. On the long end of the yield curve, we expect the 10 year and the 20 year rates to move up to 5.00 and 5.75 percent by year end, and another 50 to 75 basis points next year.

As we have said in previous occasions, the principal risks to this forecast are the huge twin deficits. Our forecast of the trade deficit of $610 billion for 2004 is consistent with our expectation that the dollar will fall in value, raising the dollar/Euro rate to US$1.35 / Euro within the next six months, as foreign investors realize that our deficits are not shrinking. On the fiscal side, we think the deficit this year will be in the $550 - 600 billion range, with minimal improvement next year unless Congress takes action to cut the hemorrhaging. The size of these deficits will contribute to increasing risks on the long end of the yield curve.