We think the Fed Funds rate will be 50 to 100 basis points higher by the end of this year. If we use the Fed’s target for the short-term real, or inflation-adjusted interest rate of 1.00 - 1.25 percent, then the Funds rate should rise to at least 4.00 percent by the end of 2005. As we have been predicting for some time, the 10 and the 20 year bond rates have increased about 60 and 50 basis points respectively, with room for another 50 basis points before the end of this year. Based on our simplistic model, we anticipate another 100 basis points through the end of 2005.

The economy is clearly on a roll following the strong GDP growth during the past three quarters. We are forecasting GDP growth of 4.3 percent this year, followed by 3.0 percent in 2005, which is lower than the WSJ consensus forecast of 4.7 percent and 3.4 percent respectively. Our lower growth outlook is attributed to our view that higher inflation, accompanied by higher real interest rates plus a weaker dollar will knock some steam off the economy’s momentum.

Notwithstanding our expectation of slower growth, economic activity is doing well in this quarter. Industrial production was up 0.8 percent in April, or 4.8 percent when compared to April 2003. Factory orders had risen 4.3 percent in March. However, consumer spending seemed to have cooled off in April.

We have never subscribed to the "core" inflation rate theory, which states that food and energy are too volatile and irrelevant in determining the overall cost of goods and services. We think it results in a misleading measure of inflation. Our longstanding 12 month moving average inflation index based on the CPI has yielded a more accurate forecast of inflation. Our April trend inflation rate stood at 2.0 percent; however, if we factor in the accelerated inflation rates for the past three months and based on the projection of monthly inflation rates during the rest of this year that are assumed to be lower than those of the previous three months, our inflation rate forecast for December is now projected at 3.0 percent. The latest University of Michigan consumer survey reveals inflation expectations of 3.2 percent. And of course, oil prices do matter.

In explaining their view that inflation is low and tame, the Fed makes a compelling point that unit labor costs have not risen with the expanding economy. However, a notable rise in input costs, particularly energy and other commodities has been the culprit in this inflationary cycle. At the same time, the Fed has pumped a lot of liquidity into the economy during the past three years in order to keep interest rates low, some of this liquidity has leaked out through demand for imports, but now the risk is that any excess liquidity in circulation will justify increasing prices. As inflation gathers some momentum, workers will seek higher wages, and thus the vicious inflationary cycle will be in full swing, but not out of hand.

The twin deficits are still casting an ominous shadow over the US currency market and are also threatening to further lift the long end of the yield curve. The trade deficit broke through the $50 billion barrier in March. We are now projecting a trade deficit of about $620 billion, or 5.2 percent of GDP this year. As we have said on numerous occasions, the US will not be able to rely on capital inflows to finance such huge deficits, since foreign investors are not loathe to throwing more good money after bad. And as a consequence, the dollar will slip to new lows by the end of this year, our latest forecast calls for a rate of US$ 1.35 / Euro.

The counterpart fiscal deficit was projected by the CBO to finish at about $477 billion, although it has recently stated that their latest forecast may be too high, due to better than expected revenue gains. However, we caution against jumping to conclusions, since the CBO forecast makes some fairly optimistic assumptions on interest rates. Based on recent interest rate trends and our interest rate forecast, the deficit could exceed the forecasted figure as a result of higher debt service payments. Federal Government debt has increased from 46 percent of GDP in 1985, to 64 percent in 2003. To put it in perspective, the size of the US government debt would not have met one of the criteria to qualify for membership in the European single currency area. Based on an outstanding amount of $6,998 billion at year-end 2003, a one hundred basis points upward shift in the yield curve would raise the government’s interest payment by a hefty amount.

The Latin American economies are being impacted this year by the recovery of external demand and by higher commodity prices. Brisk economic activity in the U.S., the principal market for the region, has been drawing a sizable amount of Latin American exports. However, higher commodity prices is a double edged sword. On the one hand, this constitutes a tremendous benefit for a region that is a major exporter of commodities. On the other hand, higher oil prices (now hovering around US$40 per barrel), have been boosting production costs and burning a hole in consumers’ pockets. With oil prices remaining firm for the remainder of this year, we expect higher inflation for the region.