The economy is neither too hot nor too cold, according to the government’s announced revision yesterday of the U.S. Gross Domestic Product.  Continued steady consumer spending and a narrowing trade deficit prompted the government to raise its estimate of the economy’s first quarter growth from 3.1% to 3.5%, which exceeds the ten-year average of 3.3%.  Many had feared that higher energy prices would dampen consumer spending more dramatically than it has so far.  Offsetting the higher costs have been wages and salaries.  They expanded considerably more in the final quarter of 2004 than the government first reported. 

Recent economic signs point to the fact that the Fed may be close to accomplishing its goal to slow the economy enough to keep inflation under control.  There are also signs in the bond markets to indicate that investors think rates are high enough.  Don Hays observes that the short-term money markets (the 90-day T-bills) have consistently anticipated the Fed’s rate hikes for the past year as they hovered just above the Fed Funds rate (set by the Federal Reserve policy board).  In the last few weeks, however, the T-Bill has resisted following the Fed Funds rate higher.  As pointed out last in last week’s Brief, commodity prices have shown signs of topping out.  Money supply growth is slow, industrial production lately weaker, and regional Fed manufacturing surveys are showing weaker activity.

Evidence of short term price pressures continue to arise here and there.  The government reported this morning that imported goods rose in April at twice the expected rate, led by higher costs of automobiles, oils, and steel.  The increase follows a gain of 2% in March, the largest in 14 years.  Most of the rise was in the goods used to make other goods.  But, as we mentioned last week, commodity prices (used to make other goods) are showing signs of peaking.  Import prices for consumer and capital goods actually fell during the month of April.

This week the markets have fared far better than last.  The S&P 500 is up almost 1% as of this morning and the NASDAQ is up over 2%.  Bonds have had a good week as well with the Lehman 1-3 Year and 7-10 Year Treasury Indexes rising .2% and .4% respectively. 

According to today’s government reports, the consumer has not wilted in the face of higher gasoline prices.  Personal spending was up more than expected in March while personal savings fell to .4%, the lowest since October 2001.  Mitigating the falling savings rate somewhat though is a healthy rise in disposable incomes.  When adjusted for inflation, incomes were up 3.3% last month from March 2004.

Will higher oil prices finally cause inflation in the U.S. economy?  Will the Federal Reserve be forced to raise their benchmark rates faster and risk stalling the economy?  These are the questions on the minds of investors and traders of stocks and bonds alike.  Recent indicators released by the government this week had opposite and dramatic effects on the markets.  The Producer Price Index released Tuesday showed that prices held steady for the month of March at the manufacturer’s level.  The S&P 500 index was up .6% and the bond markets rallied substantially as well. 

The last two days of trading have been the worst since August 5th and 6th of last year. They have taken the blue-chip index to its lowest level in five months.  What changed so drastically in the last few days?  The economy was growing, but not so fast as to worry the inflation-guardians at the Federal Reserve; interest rates were holding steady, even falling a bit; and corporate profit margins were still fat enough to absorb some unforeseen shocks, like oil remaining above $50.00 a barrel for an extended period. 

The buzz continues about the potential for increasing oil prices to ruin the economic expansion.  Indeed when oil prices fall, stocks go up and vice versa.  With crude just under $54.00 economists have had to revise their opinions of what price would trigger recession.  According to the Wall Street Journal, last summer, one-third of economists who participated in their survey said a recession would follow if crude-oil stuck between $50 and $59 a barrel, the range traded since late February.  In the latest forecasting survey, none of the economists feel that $50 oil will trigger a recession. About 31% said oil would have to be sustained at $80-$89 a barrel to snuff out growth, while 48% believe crude would have to top $90.  In inflation-adjusted dollars that is the level oil reached back in the 70’s during the oil embargo. 

The market’s bounce in February was not enough to overcome the declines in January and March sending all of the major equity indices down for the quarter.  The Dow Jones Industrials and the S&P 500 each declined 2.1% while the NASDAQ fell almost 8%.  Bond indices didn’t fare much better as the Lehman 1-3 Year, the 7-10 Year, and the 20 Plus Year indices declined by .3%, .9%, and 1.6%, respectively.  Our models performed in line with their respective benchmarks for the quarter.