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December 13, 2003

The Fed Said What?
by John Mauldin

Today we look at recent Fed statements, which give us more than a few clues as to what is really happening in the economy, plus a few thoughts on the markets.

The song in my mind the past few days has been "Free at Last." My book in progress is finished - all 24 chapters! It's in the hands of my staff and the capable editors at Wiley. They tell me it will be 400 plus pages, bordering on 500. I left about 300 pages on the editing floor. More on that below.

I can now turn to my more normal research and writing schedule, without the 800 pound gorilla on my back. AS long time readers know, each week, I typically read 150-200 reports, newsletters, books, articles and so on. I sit down on Friday and write about what themes or events struck me as the most important as we think about the future and our investments.

The letter started in late 2000 as a way of self-discipline, to force me to marshal my thoughts about the directions of the economy and the implications for the investments of my clients. We began with about 1,000 readers and today reach far more than 1,000,000. The relative popularity has been one of the more pleasant surprises of my life. What began as a monthly chore has turned into a very pleasant weekly ritual. I truly enjoy writing this letter, and I hope my work is of benefit to you.

For the last 6-7 months, most of my free research time has been taken up with various topics for the book. While it has been quite fruitful, it meant this letter strayed somewhat from its origins. While the book has produced a certain focus, it also put a rigidity in the content of the letter. This afternoon we once again return to the original focus.

With my new found freedom, I have been pondering what to take up first. There is just so much to talk about. On last week's visit with Ron Insana and Sue Herera on CNBC, they asked me, given the recent performance of the economy, did I still maintain we are in a Muddle Through Economy? That's as good a place as any to start, as it will lead us to the important parts of this week's Fed statements.

The most recent data tells us that the economy grew in the third quarter of 2003 by 8.2%, and the early 4th quarter projections show another 4% plus! That is hardly Muddle Through. That is Red Hot. Further, it is highly likely that 2004 will turn out to be a very good year, barring some shock.

How, then, can I talk about Muddle Through? Why won't things simply continue to improve? First, let me be clear that I am talking about a much longer period than just 2004. Second, as we will see below, even in lengthy Muddle Through decades, there are always (thankfully!) some powerful interludes of growth.

By Muddle Through, I do not mean some continual below trend state of growth. I mean that we must still do the difficult work of re-balancing the economic scales which were decidedly tilted in the last boom. I believe that until we have adjusted these imbalances, we will be fighting an uphill battle for growth. It can and will be done, but it will not be easy. I think it may take the rest of this decade.

I believe the annual GDP growth of this decade will be somewhat below average or less than 3% at the end of the period. There will be some very good periods when the bulls will proclaim the return of the high growth economy of the 90's, and some years we would like to avoid, in which the bears will declare the Day of Reckoning is at hand. Neither will be right, at least this decade.

Not many remember the period of the 70's as good economic times. Between 1970 and 1982, the average annual GDP growth was 2.5% and for the period was a total of 37.5%.

Yet there were years when the GDP was very high. The years 1976-79 saw back to back growth in real GDP of 5.6%, 4.6%. 5.5% and 3.2%. The average for the four years is almost 5%. (Of course, inflation for that period was over 7% annually.) Yes, the 70's had its moments. But on the whole, it could easily be described as Muddle Through.

In my opinion, the secular bear market and the Muddle Through Economy really started in the third quarter of 2000. The market collapse in March of 2000 really was the collapse of NASDAQ related stocks. In a true sense, the resulting tumble was far more than a bear market. That was a bubble bursting.

It did not have that much of an effect on other stocks until a few months later. The broader based NYSE almost reached new highs in the third quarter of that year before starting into its own bear market. The non-NASDAQ component of the S&P 500 was not in bad shape until then, and value and small cap stocks were on a run. Then came the beginning of the economic slowdown and the true beginning of the secular bear cycle.

The third quarter of 2000 was the slowest growth quarter since 1993 and the 2001 recession followed hard on its heels. In fact, the recession may have begun in 2000. The Bureau of Economic Analysis told us this week they made a small mistake back in 2000. The BEA gave us revised GDP numbers all the way back to 1929. According to the new figures, Q3 of 2000 had negative GDP of 0.5% instead of the reported +0.6%. They are evidently removing the effects of hedonic pricing of computers as they now believe it might "distort" actual GDP numbers. No kidding. Bill King sarcastically (and appropriately) wonders what effect an accurate announcement that we were in recession would have had on the presidential election? There wouldn't be any home team bias in government figure, would there? Surely not. (Source: The King Report)

Since that third quarter, the economy will have approximately grown at an annual rate of less than 2.1%, even given the explosive growth of the last half of 2003.

If the economy were to grow in 2004 and 2005 at the blistering pace of 4% as it did in the late 90's, the average growth since 2000 would still not be 3% at the end of the period, which is less than the long term trend of 3%. If the economy were to grow at 4% for the next three years before a historically mild recession (repeat - mild) the economic growth for almost 7 years would be back down to 2.5%.

A decade in which there are two recessions is almost by definition going to grow less than 3% on average. And the chances (as we will see) of the US economy getting through the rest of this decade without a recession are not good. Congress and the Fed can create all the stimulus they like. They cannot repeal the business cycle. Thus, I believe Muddle Through is still an appropriate analogy.

What Exactly Does "Considerable" Mean?

For a long time I have contended the Fed will not raise interest rates prior to the 2004 election. Up until this week, that was clearly not the consensus view. The drum has been beating for the Fed to drop the "considerable period of time" language from its announcements and start the preparations to raise rates next spring. Many economist are worried about the economy over-heating and a return of inflation. That would of course, bring out the bond vigilantes, increase rates and bring on a recession. Since as Art Cashin wrote Wednesday, the Street assumes "considerable period of time" to be at least 6 months, it is time to drop the considerable language so that the heavy lifting of raising rates can being next summer.

The Fed met this week and issued a statement which did not delete these words. The minor change was that they said the balance between inflation and deflation seemed about even, but that the risk of inflation in the near future was not high, with a nod to the fact that the economy is growing.

Martin Barnes, of the highly respected Bank Credit Analyst wrote on Wednesday, after the Fed meeting on Tuesday:

"By reaffirming its commitment to keep interest rates down for a considerable period, the Fed is underwriting continued strength in economic activity and in equity prices.

"The Fed's decision to leave its policy statement broadly unchanged suggests that it is still not convinced that the economy has entered a self-feeding expansion. Thus, the Fed does not want to risk upsetting the bond market by suggesting that policy could be tightened soon. The rise in our Fed Monitor suggests that the Fed is already behind the curve and the longer the fed funds rate is kept so far below the growth in nominal GDP, the greater the eventual danger for bonds, and the more likely that equity prices will keep rising. The odds are still good for a tightening before mid-2004."

I agree with Martin, except for the tightening statement. I make a few comments about the stock market later on, but let's look at why rates will not be raised.

On Thursday, I joined some 1,500 fellow Texas to listen to Alan Greenspan tell us that tariffs are bad, and that China is not our problem. On the way to the luncheon, I fantasized about being able to ask just one question. "Exactly how long," I would have asked, "is a considerable period of time?"

Ironically, I may in fact have gotten an answer.

BCA's statement above, and my hypothetical question, were made before the release of the minutes of the meeting from the October Fed meeting on Thursday. Rather than a brief paragraph issued at the end of the meeting, we read what was really discussed. We are given a far more in-depth idea of what they are thinking. Let's start with this paragraph. (It's written in Fed-speak, an arcane and almost incomprehensible language, so you may have to read it a few times, as I confess I am required to do.):

"In contrast to the usual experience in economic recoveries during recent decades, the expansion appeared to be gathering momentum at a time when key measures of inflation suggested that price stability had essentially been achieved. Looking ahead, members generally anticipated that an economic performance in line with their expectations would not entirely eliminate currently large margins of unemployed labor and other resources until perhaps the latter part of 2005 or even later. Accordingly and given the presumed persistence of strong worldwide competition, significant inflationary pressures were not seen as likely."

Translation: they expect that it will take at least 2 years, until "the latter part of 2005 or even later" for the economy to take up the slack in "unemployed resources" or capacity utilization.

It may be that my prediction that the Fed would not raise rates until after the election was slightly off base. It is quite possible to read the above paragraph and think that a "considerable period of time" might be two years! The latter part of 2005 is a lot further off than the November 2004 Fed meeting.

Let's look at an important paragraph buried further down in the minutes:

"In their review of the outlook for inflation, members emphasized that the prospects for persisting slack in labor and other resources in combination with substantial further increases in productivity were likely to hold inflation to very low levels over the next year or two. Indeed, many saw modest further disinflation as likely, at least over the year ahead, though they also agreed that the probability of substantial and worrisome disinflation had become increasingly remote in light of the recent strengthening in economic activity. Members also cited the weakness in the dollar as a factor that would tend to reduce the degree of any domestic disinflation. Some members emphasized that the outlook for inflation was clouded by a high degree of uncertainty about the underlying trend in productivity. The growth in productivity could remain higher than had earlier been anticipated, damping employment, labor costs, and price pressures. On balance, the members did not view changes in inflation in either direction as likely to generate significant policy concerns over the forecast horizon."

Art Cashin notes in his comment the next day: "Here again is a hint of time. They suggest the inflation horizon may be a ... 'year or two' out. Recall that much of the [recent] analysis debate over the coded meaning of what is a 'considerable period' was about time parameters within 2004. This looked like the Rosetta Stone and the hieroglyphics appeared to have an unexpected message.

"A few paragraphs on they appeared to reinforce the hint that inflation would not be a threat for a long time to come."

I inflict one more paragraph from the Fed minutes upon you, but this is important:

"In the Committee's discussion of policy for the intermeeting period ahead, all the members agreed that an unchanged target of 1 percent remained appropriate for the federal funds rate. The current degree of policy ease evidently was contributing to an upturn in the expansion of economic activity. The strengthening economy had reduced concerns of significant further disinflation, but those concerns had not been eliminated. The pickup in demand had yet to materially narrow currently wide margins of idle labor and other resources, and these margins along with the uncertainties that still surrounded current forecasts of robust economic growth suggested that an accommodative monetary policy might remain desirable for a considerable period of time. Members referred to the contrast between their current policy expectations and the typical experience during earlier cyclical upturns when it was felt that policy adjustments needed to be made quite promptly to gain greater assurance that inflation would not rise from what were already relatively elevated levels. In present circumstances, the degree of slack in resources and a rate of inflation that was essentially consistent with price stability suggested that the Committee could wait for more definitive signs that economic expansion would otherwise generate inflationary pressures before making a significant adjustment to its current policy stance.

3,000,000 New Jobs?

The theme that hits me over and over again in those minutes was: "The pickup in demand had yet to materially narrow currently wide margins of idle labor and other resources." Where," they asked, "are the jobs?" That Fed opinion can be contrasted with a significant number of economists who think the economy is getting ready to roll. The highly regarded Brian Wesbury of GKST Economics, writing today in the Wall Street Journal, is representative of this view.

"The booming U.S. economy is being fueled by what appears to be the most stimulative set of economic policies in U.S. history. Monetary policy is more accommodative than it has been since the mid-1970s. The Bush tax cuts were the most pro-growth of any since 1981. This stimulus, combined with technology-driven increases in productivity, should boost 2004 real GDP by 5% and create three million new jobs next year alone."

That is 250,000 new jobs a month, which would be a powerful recovery indeed. This probably means that Secretary of the Treasury John Snow gets to keep his job, as he "staked his reputation" on 200,000 jobs a month next year.

Except ... the economy is not yet beginning to show even a hint of such job growth. Let's look at the reasons the Fed may in fact be right to be concerned about slower than normal job growth.

For that analysis, we turn to Stephen Roach of Morgan Stanley, who slices and dices the latest rather disappointing employment numbers. Analyzing them reveals the employment picture may be worse than it appears (emphasis mine):

"There seems to be a real disconnect between the actual numbers on the hiring front and the impressions that have been formed in financial markets. Total nonfarm payrolls have expanded by only 328,000 workers over the August to November 2003 period -- an average of 82,000 per month. That's far short of the pace of job creation that normally occurs at this stage in a business cycle recovery -- somewhere in the range of 250,000 to 300,000 per month. Yet many have been quick to interpret the recent modest pickup in hiring as a sign that Corporate America is finally breaking the shackles of risk aversion and emerging from the funk of recent years.

"The mix of recent hiring trends tells a very different picture. It turns out that fully 84% of the total increase in nonfarm payrolls over the August to November period is traceable to hiring in four segments of the labor market -- the temporary staffing industry, health, education, and government -- where combined jobs have increased by 68,000 per month. In other words, the bulk of the so-called hiring turnaround since August has been concentrated in either the contingent workforce (temps) or in those industry groupings that are least exposed to global competition. This hardly speaks of a US business sector that has consciously made an important transition from downsizing to expansion. It merely reflects the fact that scale is increasing in the most sheltered and least productive segments of the economy."

That squares with the recent disconnect between the bullish Purchasing Managers Index and reality. For instance, the Chicago PMI is a rather strong and rising 55 in October, yet the Chicago area Fed tells us that production actually fell 1.8%.

How do we reconcile the two? The PMI is a survey and asks if the firms polled believe production will be up or down in the future, but not by how much. It was up for most firms, so the survey shows a positive number. But apparently, when you average the actual production of the firms, the number is negative. As an example, if 60% are up 1% and the remaining 40% are down an average of 3%, the actual production numbers would be negative, even though a majority of firms would be seeing positive numbers.

In November, the US PMI Index showed most firms planned for an increase in employment for manufacturing, while the actual numbers saw another 17,000 manufacturing jobs lost.

More evidence that the Fed is right to be concerned with a weak recovery? These notes straight from Greg Weldon's Tuesday Money Monitor (quote):

• "US Savings Accounts have DEFLATED since mid-September.
• Consumer Borrowing from SAVINGS Institutions spiked in October, and is up +7.5% nominally since the end of the 1Q.
• Average Hourly Earnings have grown at a nearly NON-EXISTENT +0.3% annualized since the end of July.
• The year-year increase in Average Hourly Earnings plunged to +2.1%, a MAJOR new SECULAR LOW, with several 'industries' now revealing outright yr-yr earnings DEFLATION.
• Two million people have been looking for work longer than 27 months, a new high in terms of the 'long-term unemployed'.

AND, in a somewhat shocking statistic, we note:

• The BLS reports that 1.024 million jobs have been lost since the "End of the Recession", with the number of Employed FALLING on a year-year basis within the November report."

Let's weave in one more quote and then see if we can draw some conclusions. I give you the summary from the December Economics and Portfolio Strategy newsletter of one of the more revered (and historically right on the money) investment analysts in the country, Peter Bernstein (an institution in his own right). He analyzes Alan Greenspan's recent speech where he asserts that the decline in the dollar will provide "little disruption":

"Then why should anyone expect the dollar's decline to be orderly, especially as so many observers and players in the exchange markets consider devaluation to be inevitable? Because it has been orderly in the past? But today's overhang of dollars is a far greater order of magnitude than in previous spells of dollar weakness. Furthermore, as value is so difficult to measure in foreign exchange markets, these markets have always shown potent tendencies toward momentum trading. A trend in place tends to stay in place for a long time. If everyone agrees the dollar has no place to go but down, why would anyone be willing to buy the dollar until it is down?

"The central banks can buy, but their resources are limited compared with the trillions changing hands daily in the exchange marts. And the central banks themselves will be in a bind, with their primary reserve asset losing value and then losing more value. The short-term interest differential is clearly against the dollar as well. Diversification of foreign exchange reserves away from the heavy concentration in dollars can become an increasing priority. The central bank flight from gold in the 1990s was hesitant at first, but once one of the central banks stepped forward, they all joined in and the price of gold fell in half.

"In the short run, American exports may gain from a weakening dollar and the price pressures from low-cost imports will ease. But at the same time, the inflationary consequences will tend to drive up interest rates here, both because monetary policy will be trying to hold the inflationary process in check and because the bond vigilantes will be back at their old habits of pushing up on long-term interest rates. This sequence of events, which does not bode well for foreign economies either, ultimately leads to recession in the U.S., which may over time return our international balance toward equilibrium but could have a devastating impact on the internal budget deficit."

The investment consequences: short if not so sweet

"No prudent investor can afford to ignore the risk of a dollar crisis, no matter how improbable it may appear. Yet markets are ignoring that outcome - which is precisely why hedging against it is essential."

The Devil and the Deep Blue Sea

The Fed minutes clearly tells us there are senior Fed officials and economists who believe that we will see more disinflation next year. Indeed, today we see the Producer Price Index dropping by -0.3%, instead of the expected rise of 0.1%.

Those who suggest that the Fed is sowing the seeds of a future inflation by holding rates down below inflation levels are more than likely right. But that is exactly what the Fed is willing to risk in order to stave off a recession and more unemployment.

If the Fed were to raise rates in the current environment, they risk hurting the housing market. Mortgage rates are roughly where they were one year ago, but mortgage refinancing has dropped considerably. Houses are still affordable, but what if short term rates and thus mortgage rates rose 2%? Does anyone but the most ardent bull credibly think that would not slow the housing market and hurt housing prices?

How would raising rates help produce more jobs? The answer is that it would not.

Falling employment would ultimately result in a recession, which is by definition deflationary. It would certainly threaten the recent rise in the stock market.

The Fed is telling us as clearly as they can, and backing it up with their interest rate policy, that they do not think the economy is poised to explode to 3,000,000 jobs next year. By telling us they intend to keep the current stance as accommodative as it has ever been historically "for a considerable period of time" which now seems quite likely to be more than one year, they imply they do not feel the recovery is self-sustaining and indeed needs more stimulus to survive.

Please note that those Fed minutes were from a meeting in which the economy was growing at 8%+! If ever there was reason to be optimistic, it was in that data. They clearly come down on the side of those who believe this is a stimulus driven economic recovery and has not yet caught fire in the broad business sector. If they thought the latter, they would be signaling that they would be raising rates soon, not talking about the latter part of 2005.

If the Fed were to raise rates, as many suggest, and the economy began to slip back into recession, a few quick cuts back to 1% might not (would not?) be enough to avoid a deflationary recession. They would be blamed for causing the recession.

The Fed clearly feels that the problems which stem from a possible rise in inflation are better to deal with than those which arise from a possible recession because they started to raise rates too soon. We will never know, because there is no way to experiment. We cannot divide the country into two parts and raise rates for one and keep them the same for the other. The Fed is managing the risks the way they see them, and we as investors will live with the consequences, good or bad.

"Long-run salvation by men of business has never been highly regarded if it means disturbance of orderly life and convenience in the present. So inaction will be advocated in the present even though it means deep trouble in the future. Here, at least equally with communism, lies the threat to capitalism. It is what causes men who know that things are going quite wrong to say that things are fundamentally sound." - John Kenneth Galbraith, The Great Crash 1929. (Written in 1954) (from The King Report)

Whither the Stock Market?

In passing, I note that the current core P/E ratio of the S&P 500 is at 27.79, and the Dow is once again over 10,000. The core P/E ratio was last this low in December of 1997. It rose over the next two years. This market can rise or go sideways for quite some time, as there is a great deal of stimulus in the economy.

It is, as Jeremy Grantham said last week, the greatest sucker rally of all time. The next recession will knock the market down much lower than the last bear market. However, that is not in the cards for our near future. The market has decided that the current trend of powerhouse growth is here for the long run. Recent history has shown us that irrational exuberance can last quite some time and go much further than anyone thinks, especially with such an accommodating Fed policy. Enjoy the ride, but keep your stops tight.

Bullseye Investing

As noted above, my book, titled Bullseye Investing, is at the publisher. There is even a proposed cover on Amazon.com, although they are not taking orders yet. That's the good news. The bad news is that it will be late April before it can be shipped, due to editing, printing, marketing, shipping and a thousand other issues. On demand publishing? Aaah, maybe next book. This was a much bigger job than I thought, and I am glad to be able to go back to my day job.

Speaking of which, I will resume writing the Accredited Investor E-Letter next month. For those who are interested and who qualify, I write a free letter on hedge funds and private offerings called the Accredited Investor E-letter. You must be an accredited investor (broadly defined as a net worth of $1,000,000 or $200,000 annual income - see details at the website.) You can go to www.accreditedinvestor.ws to subscribe to the letter and see complete details, including the risks in hedge funds. (In this regard, I am a registered representative of the Williams Financial Group, an NASD member firm.)

This weekend will find me back at the gym, before getting ready to pump up the economy with my Christmas shopping. Seven kids means a lot of shopping, but also a lot of joy. Hints have been lavishly given in recent weeks. "Gift certificates, Daddy" say my college age girls, who think Dad has not the slightest taste in clothes. I think I have pretty good taste, but they correctly point out that is because my bride buys my clothes.

Speaking of my bride, she threw a fabulous party for family and friends last night. We need more excuses in this world to throw parties and get together with friends. I think that in 2004 I will make up a few. Enjoy your weekend and your family and friends.

Your not missing the 800 pound gorilla analyst,

John Mauldin
Frontlinethoughts.com

Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA) a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. MWA is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Funds recommended by Mauldin may pay a portion of their fees to Altegris Investments who will share 1/3 of those fees with MWS and thus to Mauldin. For more information please see "How does it work" at www.accreditedinvestor.ws. This website and any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement or inducement to invest with any CTA, fund or program mentioned. Before seeking any advisors services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Please read the information under the tab "Hedge Funds: Risks" for further risks associated with hedge funds.

If you would like to reproduce any of John Mauldin's E-Letters you must include the source of your quote and an email address (John@FrontlineThoughts.com) Please write to info@FrontlineThoughts.com and inform us of any reproductions. Please include where and when the copy will be reproduced.

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.

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