23 Mar 2007 Goodbye Inflation?
The big investment news this week is that the Federal Reserve may be transitioning toward lower rates. They dropped the terminology that “additional firming” may be necessary from their policy announcement on Wednesday. However, they maintained that inflation was still their top concern. It means that, in their view, the immediate threat of inflation is low enough that additional interest rate increases are not required. Further, the Philadelphia Fed’s survey of professional forecasters found that the expected inflation rate for the coming decade has dropped to 2.35% today from 4% in 1991.
It is the primary reason the yield curve has flattened. Charles Plosser, President of the Philadelphia Bank said the difference in yields between short-term and long-term Treasury securities will remain lower as future inflation expectations subside. He said “there is less reason for long-term rates to be above short-term rates” as inflation expectations for inflation subside. Inflation is falling globally. Since the 1980s, the median inflation rate in advanced economies has dropped from 7% to 2%. In emerging markets, it has fallen from 9% from 4%.
The sway over stocks held by sub-prime mortgage defaults seems to be waning this week as well. Experts have all weighed in saying that the problem may present a drag on the economy, but few notables have called for recession (including Mr. Greenspan who was credited with the global rout in stock prices beginning in late February. During the past three weeks, the S&P 500 has risen 4%, recouping almost all of this year’s losses. Mr. Bernanke received high marks for his handling of his first securities markets panic when he encouraged investors on March 21 by saying that “the economy seems likely to continue to expand at a moderate pace over coming quarters.”U.S.stocks posted their biggest gains in eight months after the announcement.
Today, reports that sales of previously owned homes in the U.S. unexpectedly rose 3.9% in February, the biggest monthly gain in almost three years, showed that the housing market is recovering even as lending standards are tightening. Together with a gain in February housing starts reported earlier this week, it appears that housing is already becoming less a drag on the economy.
Today, stocks in the broad indexes are pushing higher, but the NASDAQ, concentrated in tech-stocks remained flat largely on Motorola’s near-7% decline on disappointing results and next-year prospects. The index rallied 2% on Wednesday with the Fed’s announcement. We expect the earnings of technology companies will outpace those of other industries during 2007 as companies beef up their information and automation systems to boost profitability and productivity.
For now, it appears that markets are returning to recent historical patterns of stability. Volatility as measured by the VIX has almost returned to 12-month average following a 90% spike in early March. Bonds have also settled down in price and are better priced for risk. Our outlook for the year remains fairly good for the economy and excellent for stocks.