Tuesday, May 03, 2005

The 2% Solution

Money managers generally believe the FOMC will be in a neutral stance when the Fed Funds rate is 2% above the inflation rate. The trick is that raising short rates and declining inflation rates can cut like a pair of scissors.

An increase in short rates is designed to slow future inflation. However, my favorite indicators of future inflation are flashing "no problem" signals. For example, the average work week has declined for the past several months. Also, vendor performance is as good as it has been in years. The rate on TIPS is only 1.6% and the rate on 10 year bonds is only 4.2%. The curve is forecasting real GNP of only 2%.

The possibility of a 10 year bond at 3.5% or lower has increased in recent weeks. A nice rally in the bond market may continue for several months. My family will continue to hold stocks. If the bond market rally continues, stocks will eventually leap. The total return on stocks over the next year or two should beat the total return on bonds handily. The next several months may be a different story.

It is hard to be bullish on bonds in the face of the real estate boom. The demand to borrow money for second homes is huge. For long rates to stay low in the face of this incredible real estate market, the dis-inflationary pressures of free trade and technology must be even stronger than is commonly perceived.

A 2% real short rate may be what money managers expect to see, but we may get there with less inflation than is expected. The unemployment claims and payroll numbers later this week will be important indicators of what comes next.