Out Of Synch?

My view for some time has been that we would have a period
of slower economic growth and lower inflation over the 2nd
half of 2006. Inflation potential has diminished significantly
although you cannot take it for granted, since the acceleration
of inflation in this cycle has been driven by commodities prices,
which are inherently more volatile than the broader economy. I
foresaw slow economic growth but no recession in the cards.
In the US, recessions begin after the economy has hit effective
capacity, overheats and undergoes a liquidity squeeze engineered
by the Fed and carried out by the banks and credit markets. No
such conditions hold sway today. There is still idle capacity,
inflation is set to cool and the banks have money to lend.

As expected, the leading economic indicators have weakened, not
enough to signal a downturn, but enough to raise eyebrows. My
view has been that lower inflation would boost real incomes,
confidence and spending before the ax fell. The inflation
primarily reflects hoarding and not overheat. I am
staying with this view and will sweat it out for a while.

To compound my felony, I have posited that 2007 would see a
stronger economy, re-ignition of inflation, and an end to the
"pause" period by the Fed. Next year is a between elections year
and may be an ok time for the Fed to go after inflation further.

Unlike most observers, I expect the stock market to progress in
a reasonably steady manner through the end of this year into the
beginning of 2007 before a top of consequence ensues and the
broad market falls by 15-20% as the environment turns hostile.

The more standard view of the market's prospects is for a rather
weak September and early October followed by a rally of substance
that could carry well into 2007, if not beyond.

One lovely thing about this business is that you get to see whether
you were right or not and to what extent.

I wrote this little screed because it was on my mind and I knew
it would bug me every time I sat down to write something. I am
going to let go for now and re-visit the projection around the
end of the year.

Geopolitical Tension Eases

The Iranian response to the UN Security Council package
re Iran's nuclear enrichment program was accompanied by
wide ranging war games in Iran and not further provocation.
A round of diplomacy may lie ahead as neither side has
definitively closed the door to further discussions.
The tenor of discussions on both sides suggests each is
laying the groundwork to blame the other if it winds up
that Iran moves on with its enrichment activities and faces
sanctions of some consequence as a result. However, no
resolution of the issue is likely right away.

The UN must accelerate efforts to bring a large multinational
force on board in Lebanon to defuse further the tension between
Israel and Hezbollah. So far, both sides are acting with
reasonable forbearance.

My intent is to get back to trading.

Oil Price ($72.65 bl)

The foiled terror plot to blow up in-flight commercial
aircraft scheduled for intercontinental transit from
London to the US created concern demand for J-9 fuel
would fall sharply and turned a normally seasonally
strong month into a weak one for oil -- at least month
to date.

The crude price has bounced this week from an oversold
and must hold $70 - 72 over the next month to maintain
the fierce uptrend underway since the spring of 2003.
Crude has also dropped inside the upper channel line
for its advance running back to 1999. Crude has had
trouble holding above that latter line for long since
the year 2000. Importantly, the issue of whether crude
can maintain the super strong three year trend or will
slide back into a much broader trading range could
well be decided over the next two months.

From a long term perspective, the seasonal outlook for
crude strongly suggests weakness from now through the end
of October. However, that could obviously change if the
US hurricane season spawns a bad one that damages
production or if Iran and the UN Security Council tangle
badly in the weeks ahead. The point here is that some
special event or series of same will likely be needed to
keep crude strong through October.

Envisioning Goldilocks

The stock market as well as bonds are buying into The
Fed's view of a slowing of economic growth coupled with
less inflation pressure. I focus on stock market factors in
this comment, as I am still not interested in bonds, which
I see as overvalued.

My SP500 Market Tracker shows the following readings for the
SP500 (now 1295):

4/06....................1307
5/06....................1270
6/06....................1265
7/06....................1293
8/06..(estimated).......1325

The Tracker did catch the spring dip and the subsequent recovery
in the market. The model has steadily rising profits over this
period with the volatility entirely explained by changes to the
yr/yr CPI%. With the sharp drop of the CRB Commodities Index over
the past 5 days, August is at least off to a good start for a
favorable inflation reading.

By my analysis, the fitful rally underway since mid-June primarily
reflects short covering and the expenditure of portfolio cash
reserves. My broad M-3 equivalent money measure is up 9.0% yr/yr
through July, while the yr/yr change in the $ value of production
is up 9.2% over the same interval. Although this has been a good
environment for profits and dividend growth, the real economy has
drained liquidity from the financial markets. The bottom line
is that the stock market likely needs both slower growth and
inflation to sustain an uptrend.

Moreover, if the M-3 equivalent measure begins to lose steam, The
Fed will have to move in quickly to provide monetary liquidity to
avoid a squeeze. An easy way to turn a soft landing into a harder
one is for the Fed to be late with this step.

Inflation in the new century has been driven by commodities prices,
especially fuels. Because commodities are so volatile, stock
players need to remember that changes in the levels of commodities
composites can quickly add to or diminish stock values. Oil has
dropped about 10% in price over the past month. It is oversold in
a seasonally strong period at present, so stock players have to
watch it closely. Note, positively, that since the production side
of the economy has been growing faster than consumption in past
months, inflation does face a headwind until production and
consumption come into better balance.

The earnings / price yield for the SP500 is now 6.3% This compares
to a 5.1% yield on the 91-day T-bill (risk free rate). The spread
is positive -- normally good for equities -- but rather thin. So,
again we see the importance of maintaining reasonable growth coupled
with more progreess in reducing inflation.

The yield curve is flat. This does not bother me as long as the banks
are lending, and lending they are at a good clip. Note though that in
an economy where production growth slows, credit demands moderate
and banks get edgier about lending. This brings us back to the point
made earlier: The Fed has to be ready to move on a slowing of credit
demand and liquidity growth.

The moral of the story is that engineering a soft landing which segues
into a "goldilocks" period is no mean feat. Recognize the elevated
risk potential.

Brief Stock Market Note

Strong rally today. My basic trend index, which measures
demand vs supply in the market, has not yet turned positive
so I am on the sidelines. Geopolitical risk remains high,
although a significant short term component of that risk
will settle out if the cease fire holds in Lebanon.

Hezbollah did its jack in the box routine to unsettle Israel
and do some strategic damage as well. It has been a bust to
date. They failed to lure Israel in to a guerilla style
battle in So. Lebanon, hit Haifa but no other strategic
targets, and now face a 30K man armed force which will
take up residence south of the Litani. Iran has pumped
about $5 billion into this operation over the years and
when it really needed Hezbollah to distract Israel from
Iran's nuclear program, Nasrallah and the boyz flopped.
Iran may hold Nasrallah's tootsies to the fire in the days
and weeks ahead, as it plays out its own nuclear program
cards. So, Nasrallah may get another shot short term, which
means this situation could remain live.

Changing Tactics

The stock market did provide a profitable rally to trade
over the 7/18 - 8/3 period, for which I am thankful. But
my view is now more cautious for the short run. My basic
trend index -- which measures buying pressure net of
selling pressure and is not a price index -- has remained
in a waterfall decline since making its high on 5/9 of
this year. the main reason has been the strong down volume
behind the declining issues over so many days since 5/9. It
suggests a relatively steadily deepening oversold for the
broad market reflecting pressure on small and midcap issues
and positive rotation into the more narrow SP500. I have
no problem with a rotation toward big caps, but I do have a
problem when the key broad barometer I use does not confirm
a positive turn in the market. At this point, I think risk
a bottom and stay out of the market until my basic index
shows some authority to the upside. For reference, the
1700+ issue Value Line Arithmetic ($VLE), a non cap weighted
index, is a price index I like.

I am also happiest trading when things going on out there in
the world are not nagging at me. I am concerned about Iran's
adventurism in Lebanon and how It will express its decision on
the incentives vs sanctions deal re its nuclear fuels program
set for Aug. 22. My concern here is that Iran, now on quite
a geopolitical roll, will overplay its hand with consequences
not good. This is a personal decision and not one I would offer
as advice to others. I have no insider insights to share on
this, just a deep concern.

If in the interim the market gets itself into high gear one way
or the other, I may trust its wisdom and play. But for now I
am in cash and on the sidelines until the geopolitical faultlines
clarify some. I will of course keep up the blog.

FOMC Meeting

The several cyclical indicators that correlate best with
changes to the Fed Funds Rate all remain strong, although
growth momentum has either rolled over or is peaking. By
my reading, the FOMC should elect to raise the FFR% yet
again.

Should the Fed elect to pause the FFR% at the present level
or perhaps signal a pause is in effect after one final boost
today, they would be operating more on an economic forecast
than on data in the can. Such a move would not be without
precedent, although the Fed usually prefers not to use a
forecast as its decision tool. The forecast that might drive
such a decision would be that the slowing of housing and
consumer spending is sufficient to lead to a slowing of
manufacturing and production growth coupled with an interim
peaking of capacitiy utlization and an eventual sharp
reduction in the growth of business short term credit demand.
These are realistic expectations, but one may have to allow the
FOMC leeway to seek a little more in the way of confirmation.

Gold Comment ($660oz.)

Gold has entered its strong seasonal period to reflect
higher commercial demand for the forthcoming holiday
and South Asia wedding seasons.

My macroeconomic gold price indicator, which went flat
for several weeks right after gold came off its May, '06
parabolic top, is again trending up, albeit modestly.
This model suggests a fair value for gold of $515 - 520oz.
With the global economy to slow further, the best bet
to keep the indicator trending up in the short run is
if oil, also in a seasonally strong period, continues to
advance.

In a 7/6/06 note on gold, I mentioned that gold would be very
overbought if it rose from its then current price of $633 up
to the $665 - 670 area. It did, and the profit takers came
in with a vengeance when the overbought was achieved.

With gold now in the $660 range on a rising 200 day M/A, the
upside limit goes to $685 - 690. First of course, gold would
have to push through last resistance up around $670.

Now that gold is off that parabolic run, traders are resorting
to more normal technical disciplines. This factor plus the
current elevated price of gold relative to fundamentals suggests
continued price volatility likely lies ahead.

Stock Market

I started out the year thinking the SP500 would wind up
2006 up about 12% to 1400, and that progress to that mark
would be relatively smooth. I have been around far too long
to take projections of this sort too seriously, preferring
instead to re-visit them for diagnostic purposes.

Right now, the market is running about 4.5% behind the
projection on a straight line basis. Given moderate volatility
standards, that is no big deal. However, the diagnosis is
of interest. The economy and corporate earnings have proceeded
about as expected. Inflation has been stronger than anticipated,
with the prices of oil and gasoline the main culprits. This
latter development has resulted in some additional shrinkage
of the p/e multiple.

Now, the economy is slowing reflecting further weakness in housing
and sluggish consumer spending. No surprises there. With the
consumer and housing slow, the production and business service sectors
can be expected to follow suit. Yr/yr % earnings comparisons will
dwindle some in the second half of the year, but the chances for a
strong market would still be pretty good if inflation pressures
were to diminish. That would allow the Fed to pause rates and
would bolster the case for a significant bump up in p/e.

The strong trend of commodities prices during the current economic
recovery has added substantially to corporate earnings, particularly
in the areas of oil and gas and industrial materials. But this same
trend has also driven the inflation rate up, resulting in
retardation of the p/e multiple. As it now stands, the strong
price trend for the commodities market overall remains in place.
Now a downshift of inflation normally follows an economic
slowdown, and there are still five months to go in 2006. At the
same time, I would have to say that the tenacity of the push in
fuels and materials prices has been something to behold, especially
since bull moves in commodities can be easily tripped up by the
development of speculative inventory imbalances.

Looking toward 2007, I am still of the mind that a decline approaching
bear market proportions is in the cards. I am guessing that the Fed
will pause short rates before this critical November off-year
election, but that It will resume raising rates at some point
next year as the economy again strengthens and inflation pressure
resurfaces.

Economic Comment

The flash GDP report showed the economy grew at only a
2.5%AR for Q2, confirming expectations for a slowdown.
Viewed yr/yr, the broad economy grew by about 6.5 - 7.0%.
This compares to yr/yr growth of dollar production of
9.0% and suggests there is inventory in the system
which could be worked off in the current quarter via
reduced production growth schedules. In turn, that may
take some pressure off industrial commodity prices, but,
it will also result in potential earnings shortfalls among
the industrial and commercial service sectors.

The stock market also took heart this week from a weaker
oil price, which reflects growing appreciation of how very
high cover stocks are.

But note that the US is just moving into a seasonally strong
period for commodities and energies, so even though a slowing
industrial sector can weigh on the commodities markets, it
in no wise follows that significant inflation moderation is a
done deal. Click here to see recent April - July lulls in commodities
price action.

"On The Way.....Wait"

Grizzled army vets will recognize the expression above as the
communication by an artillery or rocket battery that a round has
been fired. Hezbollah / Syria / Iran are calling the shots in the
beleagured country of Lebanon at present. They likely have plans that
may scuttle the current round of negotiations regarding a ceasefire
between Israel and Hezbollah and open the way to further expose Israel's
vulnerability to attack from the north. I suspect Hezbollah may have
missiles that can be fired from well north of the Litani river and
which can strike hard well into the Israeli heartland. Such a development
would greatly increase tension and danger not only in Israel and
Lebanon, but beyond.

Iran bankrolls Hezbollah and is simply calling in markers -- "Time to
earn your keep." Syria is on Iran's pad, too and is in it for the revenge.
I believe Iran wants to show the West and others on the UN Security
Council just how much clout it can wield in the Mid-East. By putting
Israel in greater danger, its message is that it can cause profound
upset in this troubled region, and that the US and others must think
long and hard about the imposition of sanctions on Iran should it elect
to proceed with its uranium enrichment programs. In short, is it worth
a broad Mid-East war to sanction Iran?

Iran promised to respond to the UN sponsored package of incentives vs.
sanctions re its nuclear programs by August 22. That gives it a little
over three weeks to have Hezbollah further increase tension and peril
within the region. As Iran sees it, this will greatly increase their
bargaining power when it comes time to talk turkey on its nuclear
development.

I lay this all out to highlight the potential for sharply increased
volatility in the capital and energy markets in the weeks ahead. All
players need to be extra diligent about positions and interests as
events unfold.

Iran accuses the US and Israel of seeking to remake the Middle East
in a way that suits them. What we are seeing is blowback from Iran
and Syria as well as Iran's declaration that it is now to be seen as a
very big player in the region. If I am right that Iran has a nasty card
or two to play prior to August 22, market players must be prepared
for another round of escalation should Israel and the US decide on a
strong reaction.

I hope I am wrong about all of this, but it just seems like straightforward geopolitical hardball to me. It need not end badly. Iran, with its additional
leverage could secure a deal acceptable to all in exchange for curbing
Hezbollah and working to cool strife in Iraq. But, since no one player
controls all the pieces on the board, matters can slip out of hand once
Iran puts its next strategic piece into play.

Stock Market -- Technical

As discussed in the July 18 post, the broad market is oversold
and due for a rally even though the basic trend is weak. Analysis
is complicated by the fact of rotation. Risk aversion has grown
since the May 09 - 10 market top. Players have moved out of small
and mid-cap stocks more aggressively than they have with the large
caps, as represented by the SP500. Through Friday 7/21, The SP
Midcap was 12.8% off the May '06 high and the SP Smallcap was down
13.9%. This compares to a 6.4% decline for the SP500.

Going into today, the SP500 is up modestly from its 6/13 low and only
mildly oversold in the short run. The weekly chart shows a deeper
oversold on a 6 - 12 week basis. The broader market is deeply oversold
across both the short and intermediate terms, with the NYSE TRIN at
a high 1.22 for the 60+ trading day span since the May top. This reflects
the compressed strong selling pressure in the small / midcap universe,
especially among the cyclicals, including business technology.

Going forward, the case for a rally reflects the strong oversold condition
of the broad market plus entry into a brief seasonally strong period which
could run out through US Labor Day (9/04). The SP500 could provide
continuing leadership, as the mood of increased risk aversion may not
reverse so quickly.

My primary indicators show a down market. Thus even if a tradable rally
is developing, it is simply unclear whether it would be durable enough
to reverse the downtrend. The work I do with NYSE breadth measures shows
that selling pressure has been trending up since early in the third
quarter of 2005, while buying pressure has naturally been trending down.
Since these volatile trends could extend for another 8 - 10 weeks before
resolving, I intend to be reserved about making market direction calls
beyond the very short term.

Stock Market -- Technical (SP500: 1227)

Back in April, I mentioned that the stock market looked best
suited to go sharply lower. In May, I put a guesstimate of
1200 as a low point for the SP 500.

I am not a sharp enough technician to know whether the market
will drop down to 1200 or not. My work indicates that the
market is weak and is growing progressively oversold. My
quandary is that my primary indicators are pointing lower,
but some key measures of oversold conditions indicate we are
very close to a tradable low.

So, as a guess, I'll go along with the idea of a low in the next
four to six trading days followed by a healthy rally.

At any rate, I am looking to go long, but since timing is not
my forte, I will wait for an upturn and some confirmation that
long is the right side of the trade.

Window Into Vulnerability

Like many others, I have been keeping up with the geopolitcal
developments of the past few weeks. There were no real surprises
until yesterday when a souped-up Katyusha rocket fired by Hezbollah
struck well into the port city of Haifa. That Hezbollah and perhaps
Hamas might now have even mildly upgraded weapons systems puts a
dangerous new spin on the Israeli - Arab conflict.

Israel will obviously want to re-establish buffer zones in southern
Lebanon as well as Gaza. Moreover It must make a fresh assessment
of its vulnerability to rocket fire, and It will want to probe
Hezbollah and Hamas positions to discern whether It may be
subject to other upgraded weapons. At a minimum, Israel will
want to establish large enough buffer zones to better protect
population concentrations. The hits on Haifa put the President of
Iran's recent comments about the destruction of Israel and Zion
into a more concrete context.

Of course, Israel always knew this day would come, when its
vulnerability to larger scale destruction would become more apparent.
To me, it adds a major new element of uncertainty to the usually
precarious mid-east military calculus.

Perhaps near term Israel can chase Hezbollah and Hamas far enough
away from its borders to secure its position and bring the
several hundred thousand Israelis up from shelters. Longer term,
Israel will have to look at how it might disable these two
hostile factions because allowing them too much proximity to its
borders could prove extremely dangerous if we are at the beginning
of an era when terror can bring heavier destructive payloads.

The easy thing for a veteran investment professional and trader like me
is to sound worldy about the current crisis and advise that we have
seen it all before and to be ready to jump on opportunities that may
come up as geopolitical tensions further rattle nerves in the markets.
But, critical differences arise from time to time, and we may have one
now with Israel in a tighter squeeze than usual.

I'll be lokking at the markets over the weekend, but I plan to study
the Israel vs. terror groups conflict with even more emphasis.

Banking System

The investment portfolio of the banking has remained on the
flat side over the past year, with banks concentrating on
expanding loans and leases. The big movers have been C&I
(business) loans and the real estate book, with both advancing
13.5% yr/yr.

With indices of mortgage origination and refinance down
substantially over the past year, it is evident that banks are
growing market share in the financing of real estate. C&I
loans have reached a level relative to the banks' investment
portfolio, where it may be expected that banks may begin to
size up loan opportunities more cautiously as system liquidity
has run down rapidly since mid-2004. Liquidity depletion is
not worrisome and has proceeded in a normal cyclical fashion,
but it is time for a "heads up" nonetheless.

Banks have funded the sharply expanded credit opportunities with the
sale of jumbo deposits -- up over 20% yr/yr -- and commercial paper,
which has increased by more than 15%.

The Fed has eased up on the brake for primary monetary liquidity,
having moved from substantive tightness through most of 2005 to
a more neutral stance. So far, I would rate this a sound move,
as demand for short term business credit can run down quickly
once an economic slowdown takes hold. Failure to anticipate
such a development can result in a painful liquidity squeeze.

Gold Note ($633oz)

Both gold and oil are moving into strong seasonal pricing
periods that run from July into October. Commercial demand
for both strengthens into the autumn.

My gold macro indicator, which jumped higher last autumn,
has progressed slowly in 2006 and has been flat since the
mid-May blowoff top for gold. Since an economic slowdown
is developing and since the Fed has moved liquidity up
only modestly this year, the best bet for gold would be
a strong showing from oil and natural gas prices as we
progress into Fall.

I noticed in browsing various sites that bullish sentiment
for gold has jumped at an astronomic pace since the recent
quick bottom and upturn in price. The gold gurus have been
piling on to the bandwagon.

My micro economic work on the gold market puts fair value
at $450-460 an oz. The macro work puts fair value at $500 -
525oz. On a short term technical basis I have gold as strongly
overbought at $665-670oz.

Interest Rate Profile / Bond Market

By my nearly 100 year regression model of short rates vs.
the consumer price index (CPI), Fed Funds should be 5.75%
rather than the current 5.25%. The Fed is pricing off key
GDP account deflators which yr/yr have moved up to 3.0%
and suggest an FFR% of 5.25%. Since I believe the CPI,
despite its many flaws, is a more realistic inflation
estimate, I conclude short rates are still on the low side,
and provide a negligible incentive to save.

Based on data at hand, short rates should still be trending
higher. However, and as mentioned in the 6/29 note, such
may not be the case by the mid-August FOMC meeting, as the
economy is slowing. In fact, my bevy of cycle pressure gauges
are nearing breakdowns, signaling milder growth ahead.

The national yr/yr CPI through May is 4.1%, about the same as
for the New York metro area. With 4% inflation, there is little
incentive for me to buy bonds, and I have stayed away from this
market for over a year. With 4% inflation, I would like to see
a US Treasury at 7% instead of the current 5.27%.

The yield curve is essentially flat in the Treasury market. A
flat yield curve normally suggests a significant slowing of economic
growth is at hand. This is because a flat to inverted yield curve
signals a liquidity squeeze is developing and that credit
availability is coming into question. Such is not the case now.
The US economy is slowing, but credit remains ample. Thus the
flat yield curve represents not so much a dark view of economic
prospects as it does the opinion of the market that a moderate
economic slowdown will reduce inflation pressure and ultimately
allow the Fed to ease again. This is born out by the continuing
tight yield spread between top quality corporates and "A" rated
intermediate bonds. The forecast implicit in current bond yields
goes beyond what I would care to sign on to at present.

The long Treasury has been rangebound between about 4.25% and 5.50%
since 2003. The market has been very sensitive to the momentum of
production growth and the trend of industrial commodity prices over
this period. Accelerating production growth and rising industrial
prices have lead to rising yields, and decelerating production
growth and quiet or declining industrial prices have provided
the bond market rallies. We may be moving into a period of
lower production growth and quieter industrial pricing that could
last for several months. So, there could be a rally in bonds. I
doubt it will carry far if the Fed keeps short rates on a plateau
which I suspect is the course it will follow. A more powerful
bond price move could occur if the economic momentum decreases too
sharply, but my indicators do not suggest that drastic a slowdown
at this point.

Oil Market & Sector

The peak driving season is well underway in the US, and
afterward, in the autumn will come the heating oil season.
In keeping, oil has entered a period of seasonal strength
which can run late into autumn. The oil price bulls are
out in force and the stocks are drawing more enthusiastic
support from analysts and pundits. There's the hurricane
season to worry over and, just to make it interesting,
the heavies on the Security Council have asked Iran to
respond to their proffered basket of goodies vs. sanctions
proposal re Iran's nuclear fuels program by July 5.

The hurricane season is a case of que sera sera. Iran
reacted positively to the goodies, but has been stalling
on responding, so the first pressure point there in a while
comes up this next Wed. the 5th.

This seasonal period for oil may be interesting not only for
issues that may affect supply, but demand as well, as an
uptrending price may, at some point, trigger much more
vigorous conservation efforts which could well come on top of
slower global economic growth. Demand for oil has been
taken as relatively inelastic. Nothing could be further from
the truth. Folks everywhere now know that the real price of
oil has jumped and shows no sign of receding. So, if you are
long the oils and the service companies keep the demand side
of the equation in firm view.

Investment managers tend to sell decelerating earnings
growth. Since oil stock earnings are very leveraged to
price, oil not only needs to rise in price this season, it needs
to rise a lot, say to $80 - 85 a bl. by late 2006 to keep the
yr/yr earnings momentum of the oil stocks at a high enough
level to maintain solid outperformance relative to the broad
stock market. That's another good strategic reason for you to
watch how demand responds to price.

To stay in the powerful uptrend underway since mid-2003, the oil
price needs to stay above $68 a bl. in the month ahead.

Now, a couple of charts. The first is a daily for WTI crude. Sure
enough, the bulls have kicked off the season. Note the nice upturn
of MACD, but note as well that the price is approaching a short
term overbought and important resistance. Click now.
The second chart is a weekly of WTI. The top panel shows the
52 week price momentum.

Monetary Policy

The FOMC is widely expected to raise the FFR% another 25
basis points to 5.25% tomorrow, 6/29. The cyclical case
for higher short term rates is still in place based on data
at hand. However, with the leading economic indicators
now signaling more modest growth ahead, a further increase
or hikes to the FFR% cannot be taken for granted beyond
this end-of-June meeting. The Fed will have a battery
of flash reports for economic activity in June to look
over at the meeting, and this fresh data can be expected
to color comments released with the rate decision.

On the liquidity front, the FOMC has tamed the Greenspan
volatilty in the Fed.'s portfolio and in the monetary base,
with both now trending in line with a shift of restrictive to
neutral. This is a favorable development from a tactical
point of view.

US Economy

Following the devastation of hurricanes Katrina and Rita
in the twilight of 2005, most economists posited a sharp
rebound over the first half of 2006, as business returned to
normal and large storm damage insurance and Federal Gov. funds
went to work. And, that's exactly what we got, with the
yr/yr dollar value of production rising to a strong 8.6%. The
Federal Reserve did not "mop up" any excess liquidity, but
the real economy did. With production growth rising faster than
capacity over most of this period, inflation accelerated, driven
by already high global operating rates for oil and industrial materials.

Unwisely, I suspect, analysts raised earnings estimates for both
2006 and '07, based on the strong showing of the economy over
most of the first half of this year.

The shorter term economic indicator sets I follow point to slower
economic growth over most of the rest of this year. Moreover,
my longer lead time indicators also point to moderation of
growth ahead.

I watch the trend of capacity utilization very carefully, because
that is a critical variable for the Fed in setting monetary policy.
In the wake of the 2001 recession, capacity utilization dropped
to nearly 74% by early 2003. Those very low readings were the
worst since the brutal washout of 1981-82, and reflected a steep
decline for US manufacturing. Since Q2 '03, the US operating rate
has recovered to nearly 82%, and if the recovery trend continued
as is, the economy would hit effective capacity and strong overheat
conditions by the end of 2007. The main or underlying reason has
been the slow growth of capacity in the wake of such a steep
recession for manufacturing.

A six to nine month slowdown for the economy would take some of the
heat off inflation potential. Moreover, capacity growth may accelerate
in the interim since producers may not want to risk the chance of
losing market share a year or two out because they have no new
capacity to meet a higher level of orders.

I think the scheme outlined above is pretty much what the Fed is
aiming for. To stay out of the political fray, the Fed may want to
pause raising the FFR% ahead of Nov. '06 elections. That would
give them 2007 to tighten further if need be, so that when the
2008 presidential election rolls around, they may again be able
to stay out of the political limelight.

My shorter term inflation indicators have softened in June, and
the longer term reading continues to show a moderate downtrend.
But these are volatile series, with a wide band of commodities
prices playing a major role. In this regard, it is easy to see
why the Fed has insistently jawboned the commodities markets in
recent weeks. Breaks in oil and other key materials would make
the Fed's job easier.