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AIC INVESTMENT ADVISORS, INC.
440 South Street, Pittsfield, Massachusetts
(October 20, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–nterest rates drifted generally lower during the third quarter with the 5-year Treasury note giving up about 30 basis points in yield, from 6.30% in early July to 5.99% in late September. The 10-year Treasury bond shed about 32 basis points during the quarter while the 30-year bond gave up a similar amount of yield. The 3-month U.S. Treasury bill began the third quarter at a discount of slightly less than 5.0%, rose to a discount of 5.17% in mid-August and then trended lower to a discount of 4.87% in late September.
Fixed income markets, in the short term, are the hostage of Chairman Alan Greenspan of the Federal Reserve Board. To date, the Fed has refrained from nudging the Fed funds rate higher, but some increase seems probable following the action of Germany's Bundesbank which increased its repo rate 30 basis points to 3.3%. The increase in German interest rates, despite a 12% unemployment rate, acknowledges the futility of attempting to reflate an economy through lowering interest rates without implementing structural changes in an economy. Japan is another example of a nation that attempted to jump start an economy through the simple expedient of lowering interest rates. That effort was unsuccessful and Japan remains mired in recession. The increase in German rates indicates that central bankers remain worried about inflation (rising prices) although, rising prices seem to be mainly concentrated in equities at this time. Mr. Greenspan has emphasized this worry on more than one occasion. In the Chairman's recent testimony to Congress, he again emphasized concern with respect to equity prices and the economy stating that the present rate of economic growth is unsustainable and that increases in equity prices at the rates experienced during the past two years are unrealistic.
The thrust of the Chairman's remarks remains focused on inflation and, clearly, Mr. Greenspan considers rising equity prices a direct result of monetary inflating. The broader M-3 money supply, as reported by the Federal Reserve Bank of St. Louis, has increased at an annual rate of more than 8.5% and the narrower M-2 money supply is rising at an annual rate of 5.6% year over year. In the past two months, the M-2 money supply has been increasing at an 8.3% annual rate. These increases in the money supply combined with the rise in equity prices are the major concerns of the Federal Reserve at this point in time. Mr. Greenspan would like to contain the rise in equity prices without setting off a series of events that could bring on recession. To date, the Chairman has elected to jawbone the situation, but without results. We suspect that he may opt for a 25 to 50 basis point increase in the Federal Funds Rate in the months ahead to demonstrate the Fed's intent to control what the Federal Reserve obviously considers speculation–as reflected in higher equity prices. Any dramatic move in interest rates appears unlikely at this time. Fine tuning remains the preferred method of monetary policy.
Richard F. Maloney
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