February 2005

On the Monetary Front

The Federal Reserve increased short-term interest rates another 25 basis points at its February meeting, marking its sixth consecutive increase. We expect that the Fed will continue to increase short-term rates during the months ahead. There are two primary reasons for these increases: one is to contain inflation on the domestic front and the other is to support the dollar in the foreign exchange markets. The latter may take on more importance following the Korean central bank's announced desire to diversify out of dollars and broaden its reserves base. Similarly, Russia has reportedly suggested denominating oil reserves in euros instead of dollars. The impact to the U.S. with the loss of foreign demand for its currency would be significant. Of course, the expectation of renewed increases in the Fed funds rate will have a negative impact on equity markets. Consequently, we continue to expect little upward momentum in stock prices during the foreseeable future.

We expect that the new administration will become more focused on the war in Iraq, sustaining the exchange value of the dollar (albeit, in a modest downward range) and somehow attempt to divert attention away from the domestic employment situation. We suspect that the government will attempt to foster controlled inflation within the 3% to 5% range and at the same time gradually depreciate the dollar within the same retrenchment range. In this manner, the administration will hope that the twin deficits, fiscal and foreign trade, can be brought under control in a manner that will not panic foreign dollar holders. The situation bears watching closely.