When the Fed began raising the federal funds rate in July 2004, almost all observers assumed that interest rates across the board would rise with it. But that has not happened. Two of the rates shown above - high grade corporates and new home mortgages - are now lower than in July 2004. A two percent rise in federal funds has no effect on the general market. One interpretation of this is that investors do not expect any rise in inflation and therefore want to lock in a moderate return while they can. This implies a slow-growing economy with no great demand for investment funds. But it also underscores the abundant supply of money available to meet such demands.

If we think about the financial underpinnings of two of our biggest markets - new cars and new homes - we get an insight into the condition of the current economy. New car buyers are offered no-downpayment terms, extended repayment periods, low interest rates, and even cash pay-back incentives. New home buyers are offered no-down-payments, interest-only mortgages, and record low 15-year and 30-year mortgage rates. These incentives not only keep the buying binge going, they are required to keep it going. Buyers simply cannot meet the minimum standards for down-payments and stable income that traditionally have been demanded. This new way of operating is fine as long as we have a rapidly expanding economy and job market, but it will lead to much anguish if that does not prove to be the case.

In any case, it is fairly clear where all the money came from; it is much less clear what all the consequences of that money creation will be.

The GDP data indicate quarterly change from one year ago. Canada and Japan show small upturns in the first quarter of 2005 in comparison with the first quarter of 2004. Germany, the U.K. and the U.S. show decreases. Industrial production weakened in the U.K., eased a bit in Germany and Japan, and remained strong in Canada and the U.S. The retail sales data for Germany and Japan show no growth over the past three years. The data for Britain and the U.S. indicate a declining trend while the Canadian data show an increase for December 2004 and a smaller increase for March 2005. Consumer prices continued their consistent trend upward except in Japan where they have actually fallen over the past three years.

The unemployment rate rose in the first quarter in Germany and Britain while declining in Canada and the U.S.; Japan's rate was unchanged.

Short term interest rates have been low for the past three years, but they started to rise in Britain and the U.S. in 2004 and the first quarter of 2005. The latest economic data indicate weakening trends rather than strengthening ones, casting doubt on whether there will be a sustained uptrend. Long term rates in general are lower than a year ago, indicating weak demand for funds. Stock indices reflect a cautious optimism, although the U.S. index was slightly lower in the first quarter.

The major trends in current account balances continued. Canada, Germany, and Japan maintained substantial surpluses while Britain and the U.S. again incurred substantial deficits. The U.S. deficit equaled 5.9 percent of GDP. The U.S. dollar declined against all the currencies shown in the first quarter.

Real GDP rose 3.8 percent in the first quarter of 2005, the same rate as in the fourth quarter of 2004 but below the 4.4 percent average for 2004. Manufacturers' new orders continued to increase, but durable goods did not contribute to the increase.

Industrial production rose through 2004 and continued at a slower pace in the first quarter. Durable goods and mining were the strongest sectors. The capacity utilization rate was the highest since 2000.

The new construction boom continued unabated through April, with substantial gains in new housing and lesser gains in non residential and government construction. Houses for sale also continued to rise moderately while the vacancy rate for rental housing remained steady at 10.1 percent. Real gross investment continued to rise sharply thanks to residential spending, equipment and software investment, and inventory accumulation.

Business sales growth slowed a bit in the first quarter, but retail sales growth remained strong. Business and retail inventory growth continued at about the same pace as in 2004. These activities were spurred in 2004 by strong growth in per capita personal consumption expenditures, and these expenditures also rose strongly in the first quarter.

Non agricultural employment grew a strong 1.3 million jobs in the first quarter. The strongest grouping was business and professional services at .3 million, but most major groupings showed increases.

National income rose $547.4 billion (a.r.) in the first quarter of which $316.0 billion was compensation of employees and $144.7 billion was corporate profits. Real per capita income rose $425 (a.r.) from the 2004 average, but real average weekly earnings fell by $.67; real weekly earnings have been falling since 2002.

Net saving rose $142.0 billion (a.r.) in the first quarter of 2005. Most of this increase was due to a decline of $90.8 billion in the federal deficit; undistributed profits rose $71.7 billion while personal saving fell $34.9 billion.

The commodity price index base has been revised to 2000=100 from 1995=100. The new data show a 35.6 percent increase in the U.S. dollar index from 2000 through the first quarter of 2005 but only a 9.7 percent increase in the sterling index, a 2.9 percent decline in the euro index, and a 35.3 percent increase in the yen index.

The rise in raw materials has contributed to a continuing strong uptrend in producer prices; since 2002 this index has risen 13.8 points.

Corporate profits increased $144.7 billion (a.r.) in the first quarter despite a sharp drop in the capital consumption adjustment. Corporate profits are about 50 percent higher than in the late 1990s, but stock indices remain well below the peaks reached at that time.

The 10 year Treasury rate by June remained at 3.95 percent despite an increase in the Federal funds rate (a one day rate) to 3.0 percent. This conundrum seems to reflect low demand for capital in the private sector, prompting strong flows into the safety of Treasuries. M-3 money supply growth slowed considerably in the first quarter to the slowest pace in a decade. The Federal deficit declined as receipts rose more than expenditures.

Commercial bank credit grew briskly, primarily for securities other than Treasuries, and loans and leases, both real estate and commercial/industrial. Consumer credit advanced at about the same pace as in the last two years.

Non financial debt grew 10 percent (a.r.) in the first quarter while financial debt grew 4.8 percent. Household sector debt increased 9.3 percent (mortgages 10.6 percent but consumer credit only 4.6 percent). Since 2000 disposable personal income (boosted by Federal tax cuts) has risen 24.5 percent while household debt has risen 50.0 percent. Federal debt during that period grew 34.3 percent. Pretty impressive changes for a five year period!

The negative balance on trade in goods and services continued to grow in the first quarter of 2005. Exports and imports of goods both rose in the first quarter compared with the fourth quarter of 2004, but the increase in imports exceeded that in exports. Services receipts, however, increased more than services payments in the first quarter.

Financial inflows for purchase of U.S. assets by foreigners slowed more than financial outflows for purchase of foreign assets by U.S. residents in the first quarter of 2005 compared with the fourth quarter of 2004, but the net difference, if maintained will still result in a new record (well over one-half $trillion).

Foreign official purchases of U.S. Treasury securities fell considerably in the first quarter, but private purchases picked up, resulting in only a small deceleration from the 2004 pace. Foreign purchases of U.S. securities other than Treasuries were down compared with the fourth quarter of 2004 but still large enough to exceed last year's record level.

Copyright © Andrew Caughey, 2005

The Pulse of Capitalism is published quarterly. Comments may be sent to Pulse Publication, P.O. Box 140, Gibsonia, PA 15044. Telephone: (724) 443-2396
Material may be reprinted with acknowledgement of the source. Economic statistics are revised routinely and may, therefore,differ from one report to another.

Published August 2005