Forecast: Good Forward Momentum
The advance estimate of economic growth for the fourth quarter of 2004 was surprisingly weak, although an upward revision is virtually inevitable, and good forward momentum apparently carried into the early part of this year.

The employment report for January showed decent growth in payroll employment and a surprising drop in the unemployment rate. That conveyed mixed messages, as the glow of lower unemployment was clouded by the specter of a tighter labor market that could limit low-inflation economic growth down the line. The actual inflation situation remains remarkably benign, although core inflation has been firming up and the Federal Reserve has been concerned about a number of specific inflationary threats. As widely expected, the Fed hiked short-term interest rates by another quarter point at the February 2 FOMC meeting, raising the federal funds rate target to 2.5%. The FOMC decision was unanimous, and was coupled with approval of requests by all 12 Federal Reserve Banks for quarter-point increases in the discount rate.

Minutes released from the December 14 FOMC meeting revealed a lot of discussion about stubbornly low long-term rates. Some members argued that expectations of longer-term economic growth had been marked down, while others believed that the extended period of accommodative monetary policy created so much liquidity in financial markets that risk-taking still was being encouraged. It’s also likely that the shift in the Fed's policy since mid-2004 has held down inflation expectations and that the Fed’s ongoing commitment to a “measured” pace of adjustments has controlled expectations of future short-term rates -- keeping downward pressure on long rates. Whatever the proper explanation, it’s clear that persistent forces are holding long-term rates down.

As a result, we’ve just trimmed our forecast for long-term rates across the 2005-2006 period by about 30 basis points at year-end. We still expect moderate increases, partly because we believe that market participants have overly optimistic views about future inflation and the amount of policy tightening that lies ahead. [ return to top ]