An Active Fed for an Active Economy

Both the short-term trajectory of the U.S. economy and the Federal Reserve’s degree of monetary intervention have changed markedly thus far in 2008. We have begun to witness a slowdown in the growth of GDP. While the advance estimate of first quarter GDP has yet to be reported, market watchers are nearly universally anticipating a number much weaker than the 0.6% growth in the fourth quarter of 2007.

Employment is also showing signs of weakness as we have watched job creation slip into net job reduction in recent months. While subject to future revisions, January and February non-farm payrolls suffered net losses. Equally significant, we saw the weakness in the Institute for Supply Management’s manufacturing sector index spill over into the service sector. While the outlook for both economic growth and employment has softened, inflation has been bucking the trend. Both the Producer and Consumer price indexes have ticked notably upward. One substantial cause of this rise in prices can be traced to the growing demand for commodities. The most visible effects have been oil’s run to triple-digit prices and gold’s recent rally to breach $1,000 per troy ounce.

To help mitigate the effect of an economic slowdown, the Fed has been very active. The Fed has been very aggressive in cutting both the Fed Funds and Discount rates. So far in 2008, the Fed has cut these rates by 2.0% and 2.25%, respectively. More notably, the Fed has injected liquidity into the market in creative ways ranging from minor modifications to existing methods to uncharted territory. Future policy action will depend on both the economy’s growth trajectory and the strength of the U.S. dollar. The latter continues to be the subject of intense focus as the greenback has hit cyclically low milestones against the euro and the yen. 

Risk and Uncertainty Yields Volatility

While the extent of future Fed policy action is difficult to predict, the degree of short-term market volatility is not. The recent ingredients folded into the market’s recipe have continued to yield more volatility. The primary ingredients have been the continued housing market slump, the subsequent spillover from the credit markets into broad equities and the economy, a decline in corporate earnings, and increased investor aversion to risk. In light of these events, the start of 2008 has brought with it falling U.S. Treasury yields (rising prices), and falling stock prices. Both have resulted from a general flight to quality from riskier stocks and bonds. Investor experience for the rest of 2008 will depend greatly on the direction of corporate earnings, interest rates, investor risk appetites, and the unfolding of the Presidential election. While the financial markets have historically provided positive performance during the last year of a President’s term, the degree of uncertainty on several fronts suggest that 2008 may represent a historical aberration. Given the range of sources of uncertainty, investors should continue to expect volatility—both to the upside and downside—as market participants continue to revise their short-term forecasts and re-price risk accordingly.

In times of increased market volatility, it is helpful to remember one’s long term goals for investing. An investment policy statement, which incorporates these goals and a long term historical market perspective, acts as a mission statement for an investment portfolio. Referring back to this mission statement during volatile times will help guide investors to reduce the emotional behaviors of fear and greed, thereby providing an investor with increased ability to buy low and sell high. Those investors without such ability will often make the mistake of doing the opposite, most likely to their own detriment.

Originally enacted in 1981, the federal research and development (R&D) tax credit has again expired as of Dec. 31, 2007. Overall, this means a $9 billion tax increase for the nearly 11,000 companies of all sizes that utilize the credit. While there’s every reason to believe it will be extended yet again—the credit has been extended 12 times since its inception, and there’s only been one 12-month period where the credit was not in effect—many companies remain understandably concerned. The key is not to panic. There are steps we can all take to encourage Congress to enact a multi-year extension of the credit or, even better, make it permanent.



Plante Moran Financial Advisors (PMFA) provided this article to convey general information about market and economic conditions and not for the purpose of providing investment advice. Investment in any of the sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment regarding your own situation.