We think the Fed has been emphatic in its position of not increasing the Fed Funds rate, and thus we see no change at the next FOMC meeting on October 28. The Fed will insist on keeping the Funds rate at 1.00 percent at least through the first quarter of 2004. As we have said repeatedly, inflation is starting to creep up and the dollar has not yet seen the low point, thus events are likely to force the Fed to move sooner than later, possibly in the beginning of next year. As we had predicted, the long end of the yield curve has started to move up. The 10 year and 20 year bond yields stood at 4.32 percent and 5.27 percent at the end of last week. This trend will continue through the end of this year, with another 50 to 75 basis points increase in the long end. Thus the Fed will have created one of the steepest yield curves on record, at a time when the economy is trying to gather steam, not a pleasant combination.

Understanding monetary policy now involves partly a word game, where market participants are required to interpret the Fed’s cryptic statements. Since May of this year, the FOMC has been warning of an “unwelcome substantial fall in inflation.” Normally, a drop from 2.4 percent (the current rate) to 0.0 percent inflation would not be considered as a substantial fall, more likely a decline in prices, or negative inflation, would be a more accurate description of a “substantial fall in inflation.” Fed Chairman Alan Greenspan clarified this question during his Congressional testimony on July 15, when he stated: “there is an especially pernicious, albeit remote, scenario in which inflation turns negative against a backdrop of weak aggregate demand.” We concur with this interpretation; and for that reason have been commenting in our previous StratAlerts that the Fed needs to provide more information substantiating a prolonged decline in prices, since the CPI is still growing at a 2.4 percent annual rate. On the other side of the word game are the Fed’s attempts to talk down long-term interest rates, since it is highly unlikely that the FOMC could engineer an interventionist policy to actually trade down long term rates. Starting with the August FOMC statement, the Fed has been stating that it will keep the Funds rate at its current 1.00 percent rate “for a considerable period.” Usually, that phrase would be interpreted as meaning a period longer than a year. Nevertheless, we think the use of the word “considerable” is aimed at market psychology regarding  the long end of the yield curve. It is thus an attempt to convince investors that long-term rates should trade against an expected inflation of 1.0 percent, something we find unlikely.

There is a growing feeling in the market that the economy is gathering momentum. In fact the Wall Street Journal (WSJ) survey of economists calls for 5.0 percent GDP growth in the third quarter of this year, followed by 4.0 percent in the fourth, and a relatively robust rate in 2004 of 4.0 percent. We differ with that assessment. Our forecast calls for a fourth quarter year over year GDP growth of 3.0 percent this year, compared with a rate of 3.5 percent for the WSJ survey. Consumer spending and housing construction is still going strong, but we think consumers are likely to take a breather sooner than later, and then resume spending but on a more moderate track. The fiscal stimulus from the tax relief package has helped this year, but it has also contributed to the surge in the fiscal deficit, which is starting to bump up the risk premium on long term interest rates. 

Weak employment numbers are dampening consumer expectations. We think part of the problem has been the shifting of manufacturing overseas, leaving a rising structural unemployment rate. As a consequence, we expect the unemployment rate to show very limited downward movement during this expansion due to the outsourcing of jobs overseas. The stubbornly high unemployment rate has affected commercial real estate vacancies, particularly office space, as companies continue to downsize in order to avoid rising costs for benefits and other employment related costs. 

Inflation should end this year at an annual average rate of 2.4 percent, of course, this is based on the CPI measure of inflation, AND including food and energy. The University of Michigan showed consumer inflation expectations at 2.5 percent based on their August consumer survey. We find it hard to explain how the U.S. economy can grow at an annual rate of 4.0 percent, above the trend rate, with rising commodity prices, and a declining inflation rate. That is why we expect a moderately higher inflation rate for 2004, between 2.75 and 3.0 percent, in contrast to the Fed’s byline: print money, no inflation; but as we have explained, the persistent expansion in domestic liquidity has actually “gone out the back door” through a hemorrhaging of the trade deficit and the balance of payments. 

We still forecast a runaway trade deficit that is headed to 6.0 percent of GDP next year, based on the recent upward revisions to U.S. economic growth. Once again, we  predict that this will lead to a substantially weaker dollar, with the Euro reaching $1.30 /Euro during the first quarter of next year.

                                             Latin American Economies

 The coffee crisis, now in its fourth year, has not touched bottom yet. At the end of the coffee season, from October 2002 to September 2003, coffee producing countries in Latin America are reporting continued declines in exports and production. This last season has been the worst in the last 45 years in El Salvador, with production plummeting by 25 percent and exports tumbling by 14.5 percent. Costa Rica is not expecting better results for next season either. Early estimates indicate another fall of 2.4 percent in coffee production.