What Inning Are We In?

S&P thinks the Federal Reserve will continue to be vigilant on inflation, but may skip a rate hike in August

By Joseph Lisanti

Americans love sports analogies. Combine one with a suggestion that the Fed might stop tapping the economy's brakes, and traders can get excited.

When the head of the Dallas Federal Reserve Bank described the upcoming Federal Open Market Committee meeting as the "ninth inning," some people inferred that the Fed was getting ready to pause in its efforts to tighten monetary policy. Ignored was the official's observation that "extra innings" might be needed to quell any incipient inflation.

We believe that the Federal Reserve continues to be concerned about inflation. Although the May payroll employment gain of 78,000 was relatively weak, hourly earnings were up for the month, following a sharp rise in first-quarter unit labor costs. That suggests to us that another quarter-point increase in the fed funds rate will be announced at the June meeting. After the next increase, the Fed may pause in August if job growth continues to be sluggish and inflation appears tame. We do expect the rate increases to resume, however, in order to reach a "neutral" fed funds level of 4% to 4.25%.

Maybe we are in the ninth inning of fed funds rate increases. But baseball fans know that innings have no time limit. Even a nine-inning game can be a protracted experience.

If baseball is slow, its pacing appears rapid compared with the European economy. Euro zone gross domestic product increased at a lackluster 1.8% annual rate in 2004. We had been looking for a slight increase to 2% in 2005. But in light of an uncertain capital spending picture and the possibility of more profit warnings in the second half, we have cut our growth estimate to 1.3%.

As a result, we advise slightly trimming exposure to Europe. Although we are maintaining our 20% allocation to foreign stocks, our model exchange-traded fund portfolio moves the 5% of assets in the S&P Europe 350 index to the broader MSCI-EAFE index.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook

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