Market Outlook: The Fed Four Step

Market Outlook: The Fed Four Step

November 14, 2003

By Kenneth L. Green, CFA

In a ‘garden-variety’ recovery, which we are experiencing, there are four steps leading to the Federal Reserve tightening monetary policy, thereby raising the general level of interest rates.

Step 1 The stock market foresees/predicts economic recovery by advancing sharply. We are deep into this phase. So far in 2003 the NASDAQ and S&P 500 indexes are up 45% and 20%.

Step 2 The economic growth statistics begin accelerating. We are well into this step. America’s Gross Domestic Product (GDP) growth has expanded dramatically in 2003. First quarter GDP grew by 1.4%. Followed by 3.3% growth in the second quarter and culminating with 7.2% growth in the third quarter.

Step 3 The job market improves. We are in the beginning stages of this process. Throughout the summer and fall, the financial media have often reported of the apparent "jobless recovery". Intuitively, we should all recognize that Corporate America only adds to payroll and capital investment once their business prospects have improved. The last three months have provided a much clearer picture. There were 35,000 net jobs added in August, 125,000 added in September and 126,000 in October.

Step 4 Inflation pressures begin to build. This phase is yet to come. However, in our opinion, the groundwork has been laid. With the 2003 tax cuts and the Fed’s accommodative monetary stance, it is only a matter of time until the economic momentum begins to impact prices for commodities, finished goods and labor.

As we get closer to finishing the ‘Fed Four Step’, the closer we come to higher interest rates. In order to keep inflation under control the Federal Reserve must begin raising rates. While the timing is still to be determined, the process is well under way.

In this interest rate environment, portfolios with a short to intermediate duration and a focus on high quality bonds will outperform their peers.