At its October 28 meeting the Fed once again kept the Fed Funds rate at 1.00 percent. We expect Mr. Greenspan to don his Santa Claus outfit at the next FOMC meeting on December 9, for an early Holiday special when the Fed will once again vote in chorus to hold the Funds rate at its current level, and thus fill consumers with more good cheer that will entice them to open up their pocketbooks and spend their borrowed wealth.

The Fed’s statement released after the October FOMC meeting mentioned that the probability of an "unwelcome fall in inflation exceeds that of a rise in inflation." Once again we are perplexed by this statement since the 12 month moving average inflation rate was running at 2.3 percent in September, up from 1.6 percent last December. The Fed’s statement also reiterated its intention not to raise the Fed Funds rate for a "considerable period." As we have explained in previous Briefings, the use of hyperboles has become the Fed’s latest monetary policy instrument to bring down long-term interest rates. It is based on the notion that you can fool the markets by relentless repetition of the phrase "considerable period," a Pavlovian rallying call for investors to jump for bonds.

The third quarter GDP release was just what the doctor ordered for a limping economy. The 7.2 percent growth rate surpassed the highest single quarter rate recorded during the post-1990 recovery, thanks in part to a good dose of fiscal stimulus. Consumers led the way with 26.9 percent growth in purchases of durable goods and 7.9 percent for non-durables. Businesses appear to be signaling increased optimism about the economy as shown by the 11.1 percent growth of fixed investments, which follows a 7.3 percent expansion during the second quarter. Residential investments also took off with 20.4 percent growth. In a surprisingly positive outcome merchandise exports posted 9.3 percent growth, while imports declined 2.6 percent. The devaluation of the dollar may have triggered an early therapeutic response in the external accounts. Because the third quarter was so strong, we expect the economy to cool off during the fourth quarter, with 3.0 percent growth, and then to coast at an average rate of 3.8 percent in 2004.

During the past three months the 20 year - 3 month Treasury yield spread has averaged about 4.25 percentage points, an unusually steep curve. The inflation-adjusted 10 year bond has averaged 1.8 percent year-to-date, in contrast to historical rates of 3.5 percent. Our calculation is based on the CPI index, using a 12 month moving average process, and we do NOT exclude food and energy (Perhaps this is the definition of the popular but nebulous term the New Economy: the Old Economy excluding food and energy). The steepening of the yield curve marks the Fed’s unflinching and uncompromising view that there is no inflation, but rather the risk of deflation, and that the economic recovery is likely to stall at any moment.

Apparently most market analysts as well as our policy makers view the dollar’s plight and the gaping hole in our balance of payments are just a symptom of market paranoia. This type of reasoning suggests that the value of the dollar vis-a-vis other currencies is irrelevant; what matters is that our monetary printing presses are churning out more greenbacks at a fast and furious pace, yet as our policy makers have assured us, there is no inflation in the foreseeable future. Well, to err is human.

Several factors should conspire to further steepen the yield curve, and thus compromise the growth of the economy in the medium-term. The heating up of the economy, the up-tick in the inflation rate, the surge in the fiscal deficits, and the wobbling dollar are expected to add another 50 to 75 basis points to the risk premium in the long-end of the curve. Consumers appear to be wiser when it come to their views on inflation than Wall Street investors. The Fed’s "look: no inflation" tune has been falling off the popularity charts, as consumer inflation expectations have risen from 1.7 percent in July of this year to 2.8 percent in September. The latest CBO forecast for the 2004 fiscal deficit calls for a whopping $500 billion shortfall. Not to mention our continuous drum roll for the towering trade deficit. Markets are sometimes ruthless when correcting out-of-synch prices, and in the case of the dollar, we anticipate an unpleasant start of the New Year with another slide of the dollar which could send the value of the Euro to US$1.30 / Euro.

We think there is a disconnect between the Fed’s view that deflation is more likely than inflation – despite the fact that inflation has actually been picking up during the past year, with the notion that the economy is going to continue to recover, including a rebound in the industrial sector, which would imply demand-driven price increases. At the same time, we find an inconsistency between the Fed’s view that that real – or inflation adjusted interest rates, should decline further, even though they are already at historical low levels, and the expectation that the economy has embarked on a healthy recovery, while the twin deficits, external and fiscal, are bulging to unsustainable levels, factors that would normally lead to higher risk premiums on the long-end of the yield curve. Because of these cross-currents, we think that markets will encounter some turbulence in the coming months, that could be exacerbated by election year politics.