It’s All Relative
The U.S. Treasury market, as represented by the Merrill Lynch Global Government Index, declined by 0.4% during the first quarter of 2005. This represented the worst performance registered by any of the 19 government debt markets monitored by the firm.

This month’s What Counts composite forecast of leading economists estimates year-end rates on Fed funds and 10-year treasuries at 3.85% and 5.03%, respectively. The yield curve continues to flatten, and the implied forward yield curve (Figure 1) indicates limited potential for steepening anytime soon.

Figure 1. Implied Forward Swap Yield Curve

By global standards, as measured by short-term rates, the Federal Reserve Board appears to be pulling tighter on the monetary reins. By the Fed’s continued admission, at current levels, monetary policy remains “accommodative.” At 2.75%, the Fed funds rate is now 75 basis points higher than the European Central Bank’s benchmark rate of 2.00%. Meanwhile, the central banks of Australia and Britain appear to be in the final throes of a tightening campaign, while Japan’s short-term rate remains near 0%, virtually unchanged from 2001.

Figure 2. Comparative Global Short-Term Rates

The “A-Word”
It will be interesting to see if the Fed continues to openly define its policies as “accommodative” by the Federal Open Market Committee’s May 3 meeting. When will the Fed strike the “a-word” from its vernacular? When sufficient evidence accumulates, showing that:

	Businesses continue to have a difficult time passing along their higher costs to their customers. In its most recent release, the Fed noted that “pressures on inflation have picked up in recent months and pricing power is more evident,” (but)….”the rise in energy prices has not notably fed through to core consumer prices.”
	Inflationary pressures remain neutralized. Evidence here remains mixed. Although the annualized Consumer Price Index (less food and energy), which, at 2.4%, is now double last year’s pace, the Fed’s preferred measure of personal consumption expenditure inflation remains tame at an annual growth rate of 1.6%.
	Productivity decreases. Productivity since 2000 has been double the rate of the inflationary 1970s, and capacity utilization increases stabilize.

The Consumer and Capital Sectors: Still “Good to Grow?”
The U.S. Commerce Department’s final report on fourth quarter 2004 GDP reaffirmed an annualized growth rate of 3.80%, making 2004 the most expansive year since 1999. The yawning trade deficit subtracted 1.35% from the overall growth rate. Nonetheless, during the fourth quarter, consumer spending grew at an annual rate of 4.2%. With the disappointing creation of 110,000 jobs (roughly one-half of anticipated levels) in March, consumers appear to be drawing down savings—a phenomenon that cannot last in perpetuity.

Several months ago, we cited anecdotal evidence from our members that commercial and industrial loan growth was accelerating. Indeed, the Federal Reserve’s latest Flow of Funds Report showed that non-financial company borrowings during the last quarter of 2004 were at their highest level since early 2000. It remains to be seen if increased corporate borrowings, combined with escalating Treasury borrowings, might incrementally pressure interest rates. Moreover, the additional supply of corporate debt could widen credit spreads, which remain at a historically narrow point.

Figure 3. Comparative Yields: 10-year Treasury Note vs. 10-Year BBB Industrial
Corporate Bonds

Chairman-in-Waiting?
With the expiration of Alan Greenspan’s term as Chairman of the Federal Reserve Board in nine short months, the market will become increasingly focused on his replacement. In the spotlight, Ben Bernancke (one of the more outspoken members of the Fed) was recently tapped to chair the President’s Council of Economic Advisors. Mr. Greenspan previously served as the Council’s Chairman under the Ford administration.

The longstanding favorite, Harvard economist Martin Feldstein, appears to have slipped in the rankings as of late. Feldstein, formerly Chairman of Ronald Reagan’s Council of Economic Advisors, presently serves on the board of AIG, a re-insurer that is undergoing regulatory scrutiny. Another former Chairman of the Council, currently Dean of the Columbia University Business School, Glenn Hubbard, is also considered to be in the running.

Mr. Greenspan’s successor will take on the somewhat divisive issue of inflation targeting as the primary objective of monetary policy (as opposed to price and employment stability). Mr. Greenspan is on record as seeing the creation of a numerical inflation goal as a constraint against the Fed’s ability to respond to economic changes. Dissension within the ranks of the Federal Open Market Committee was readily apparent in the minutes of the February 1 meeting. It’s interesting that Mr. Bernancke, in recent statements, has increasingly voiced his support of an explicit inflation target.

John Biestman is assistant vice president, IMS consultative sales advisor at the Federal Home Loan Bank of Seattle.

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