As we had predicted, the Fed raised the Funds rate to 1.75 percent at its September 21 FOMC meeting. The FOMC statement was written by a real two-armed economist: "on the one hand it states "the stance of monetary policy remains accommodative," and on the other, "the Committee believes that policy accommodation can be removed at a pace that is likely to be measured...to fulfill its obligation to maintain price stability." We expect the Fed to raise the Funds rate again at the November 10 meeting to 2.00 percent, and in keeping with their measured pace strategy, as in 25 basis points per meeting for this calendar year, another 25 basis points at the December 14 meeting. At that point the Fed could take a breather. Central Bankers usually prefer to take the medicine in one dose, albeit in gradual sips.

So far, the increases in the Funds rate have not impacted the long end of the yield curve. Analysts explain this by saying that investors believe that the economy is stuck indefinitely in a "soft patch." This is logical, if we consider that markets usually apply linear thinking to economic matters, where the projection is based on the last month’s headlines. We on the other hand, recognize that the relationship between expected inflation, real interest rates, medium-term risk factors (fiscal and trade deficits), political uncertainties, short-term monetary policy and the long-end of the yield curve is not a linear one, but always changing dynamically, although the basic interest rate equation still holds, that nominal interest rates are determined by the real interest rate, which unfortunately cannot be observed, plus expected inflation.

Inflation has cooled off slightly. In previous StratAlerts we had predicted an average inflation rate of 3.0 percent for this year (based on our 12 month moving average), we have now reduced that projection to 2.7 percent. The University of Michigan’s consumer inflation expectation survey shows consumers’ expectations declining from 3.3 percent in May to 2.8 percent in August. If the Fed continues to increase the Funds rate in even steps as described above, then inflation could be kept within the 3.0 - 3.35 percent range next year. Otherwise, maintaining an accommodative stance, even with moderate growth of the economy, could unleash disruptive inflationary pressures, thus the Fed is acting wisely now so as not to regret it later.

According to Fed Chairman Alan Greenspan the economy entered a soft patch in June. Second quarter GDP growth was 2.8 percent down from an average quarterly rate of 5.1 percent during the previous four quarters. Rather than a "soft patch," we think this reflects the normal cyclical swing following the initial expansion period after a recession. Consumer demand for the interest rate sensitive durable goods has waned, particularly motor vehicles, while business investments in equipment and software and investment in residential structures continue to expand at a healthy pace. On the other hand, the volume of imports continues to surge at double digit rates. We expect the economy to slow moderately in 2005 to 3.0 percent growth.

The above factors lead us to the following conclusions regarding the expected path of the yield curve:

According to the latest IMF report on world financial stability, the Chilean banking system is the most robust and stable in Latin America. Chilean banks are in a position comparable to Italian and Austrian banks.