Today's Commentary: 02.09.07
The 2007 Budget

All budgets, whether they be your own household draft or the mess the president submitted, really need at its core intelligence, imagination and wonder.

Today's Commentary: 02.04.07
Do You Know Where the Economy is Headed?
Vince, a local produce manager in Portland Oregon recently quipped about the easiest way to increase his daily sales totals by ten percent. Pick a popular item and raise the per pound price by a dollar. A nasty freeze in California, the breadbasket for this countryıs unjuiced oranges, threaten supplies of the fruit throughout the grocery business forcing across the board increases for citrus. This time of year, oranges are a very popular item.

The green grocer was instructed by his buyers to shrink his display and increase the price. The belief that the buyer of an in-demand item, especially one carrying a grocery list with oranges on it, would recognize the price increase for what it was and reduce consumption, perhaps eve chose a different, more economical item. It made good business sense. Inflation, in theory at least, slows the consumption of a good by making the item too expensive to be purchased. The shoppers at Vince's store paid no mind to the diminished display and kept buying what they wanted in the quantity they desired, completely missing the companyıs attempt to slow the item down.

What happens to that lost cash? As the shopper walked the aisles, subtle price increases were everywhere, inflating meat, cereal, and paper products. Last yearıs regular prices are this yearıs advertised special. And thatıs just in the grocery store. This kind of inflation is removed from the as-yet-to-be-released core inflation number. It is this number, expected to rise one to two percent that is used by the Federal Reserve Board when they debate rate increases.

The Fed chairman Ben Bernanke, celebrated his first year at the helm by holding the rate they charge their largest customers at 5.25%. Amidst the kudos for having navigated the economy through an enthusiastic period in the stock market, a dismal stretch for the bond market and of course, the slowdown in the housing sector, the Fed saw fit to hold steady. The markets got a somewhat dovish statement suggesting that holding steady was by no means a hint that they might start cutting those short-term rates.

Before I ask whether we are all looking at the same economy we should get the givens, the what we know out of the way first. The recent stock market move has been no secret. Much like the pricing of the oranges above, the robust and bullish run we have been on can be directly attributed to the capital gains tax reduction to 15%. Locked-in money, a reference to equities held for the long-term in hopes that a favorable tax rate would permit their sale, suddenly had just such a rate. Sellers sold and then became buyers tumbling all over one another looking for bargains.

Enormous amounts of old wealth was suddenly re-circulating and buying a stock market that was producing profits primarily through access to cheap money. That favorable borrowing environment, even at the current rate permitted share revaluations with buybacks, lots of M & A activity and the influx of boatloads of private equity. (It should be noted that stock buybacks donıt eliminate the number of shares- stock is never completely gone, the available supply has been reduced.)

The markets surged and continue to do so. The question is why. Many of the recent reasons to buy with abandon are no longer there. Good news is no longer as exciting but still running on the positive side. Inflation may be increasing as the economy moderates but that is to be expected. So far, pressure on wages has not increased the way a normal inflationary cycle would suggest and yet businesses are concerned that this year wonıt be the same as the last.

Another given is the increased tax revenue. This additional $35 billion will go a long way except but not as far as you might think. Letıs put it this way, it is not going to pay down the debt. This quarter, because of taxpayer largesse, the Treasury Department will only need to offer the world $141 billion in bonds.

The bond market seemed to like this firm stance on interest rates and began to openly hope that by mid-year the Fed would begin loosening the purse strings a bit. Signs of economic softening came from a weak jobs number (more on that in a moment) and the tepid report from the Institute for Supply Management. Their monthly survey of member supply managers numbering 40,000 released on the first of each month suggested that the economy was poised to contract. Considered a near-term indicator, the manufacturing index fell to 49.3 from December's level 51.4. Any number less than fifty does not indicate the kind of moderation that Mr. Bernanke is attempting to hit. Instead it points to a possible landing that might prompt the Fed chief to ease somewhat.

The report also reveals a significant drop in exports, an overall increase in costs of raw materials and five straight months of contraction when it comes to backlogged orders.

What does this for employment? Our final given is the jobs report. You can count on a revision upwards in the next month if the trend of previous reports is any indication. In each of the five previous months, manufacturing jobs lost ground

with the services, social and governmental hiring showing growth. With the unemployment rate inching up slightly to 4.6%, the Fed is likely to stay put on rates. To them, a fully employed market signals a smaller labor pool and that in turn increases wages. That puts inflationary pressure on prices.

January employment table from ISM report.

Employment	% Higher	% Same	% Lower	Net	Index
Jan 2007	14	68	18	-4	49.5
Dec 2006	14	68	18	-4	49.4
Nov 2006	17	63	20	-3	48.9
Oct 2006	17	63	20	-3	50.6

How much of a change in the unemployment number would force the Mr. Bernanke to reconsider his position and more importantly is the number of jobs and the unemployment rate a good indicator of production?

Lower gas prices and a relatively warm winter have left the worker with a little more cash in hand than the economy would have suggested. This allowed for a little freer spending and took pressure off employers to increase wages. It also increased the number of 150,000plus predictions. Regrettably, that is period is at an end.

San Francisco Fed president Janet Yellen has even suggested that the economy may be more robust that the jobs number indicates and that may force the Fed to reevaluate its stance. This is not what the fixed income investor wants to hear. With one of the key factors the Fed considers in its rate adjustment now in question, one has to wonder whether productivity or lack of it force an unwelcome rate change?

If employers are continuing to create jobs, as the revised month over month numbers indicate, then the possibility that productivity has slipped increases the chance of another interest rate increase. That is not what the bond market wants just as it attempts to get its footing.

It is not what the equity markets need either. What worked for the Dow Industrials to help get them to this point will not work moving forward should the Fed move opposite of wishful thinking. Commodity price adjustments will be hard enough for the economy without easy access to cheap money.

And if indeed the revised jobs created last year was up by a million over what was reported and productivity failed to follow, inflation without wage pressure will make buying higher priced oranges (gas and housing) doubly difficult.

Previous Commentary available here

BlueMoney Report

The Blue Money Report
Financial Commentary covering a wide range of topics concerning money, investing, and how it effects the average investor and their financial health.

It is the World of Money and Investing Explained.

Our Publication
If you are interested in providing your readers with our syndicated column, you can request it here

---