The Fed raised the funds rate on September 20th by 25 basis points to 3.75% and the bond market cheered loudly. This was the 11th straight rate hike since June of 2004 and odds favor at least one more upward move this year. While inflation is almost completely isolated in the energy and housing sectors, with the rest of the economy well contained, the Fed argues that housing and oil are serious threats going forward. Unless something unforeseen surfaces in the 4th quarter, the Fed will likely raise the funds rate to 4.00% at either the November 1st or the December 13th FOMC meeting. With the bond market cheering the Fed for staying ahead of the inflation curve, it is reasonable to assume that the yield curve will remain virtually flat. Our sense is that the Fed will take a time out after one more rate increase but will not hesitate to move again if inflation becomes worrisome.

Our concern at the moment is the potential for a slowdown in the 4th quarter due to Katrina and Rita as well as slumping auto sales and huge losses in the airline industry. Even if GDP drops below 3.00% in the 4th quarter, it should rebound in the first two quarters of 2006. But, the short term prospects are worrisome. The index of leading economic indicators fell in August with downward revisions to previous months and this was prior to Katrina. While the increase in the price of oil preceded the hurricane devastation, the damage to the rigs and refineries in the Gulf will keep pressure on the price of oil for the remaining days of 2005. So, the big question is whether the hurricane damage and the high price of oil will send us into an economic recession and will the Fed go too far in its effort and derail this powerful U.S. economy?

We like to look at the Dow Jones Utility Index (DJUA) over time as an excellent barometer of just how good our economy is doing and is going to do down the road. Prior to the past 5 years Utilities have been a sign of people wanting to buy interest rates/dividend yields. But, that has all changed as the Utilities have cut their dividend pay outs when revenues are not there, meaning they make power and sell it. Power can not be stored then pushed out the door under the Employee Cost Program that we see in the auto industry. So, looking at the Utility Index going back prior to 9/11 we see the index was on the way down as the economy was already slowing down. After 9/11 the country pushed further into an economic funk as the index continued to drop. Now, we are at a new all time high which suggests that the economy is just fine. Plus, we think that this index which has made higher highs all during September, after both Katrina and Rita, says that the economic expansion remains intact. This is a tremendous difference from what we saw after 9/11.

A little philosophy is in order. We think that for all the bad resulting from the hurricanes, the U.S. has an excellent chance to make things a lot better on all fronts. Think of the Gulf region in the way FDR did about the TVA program in the 1930's. He said we were going into this depressed area and put people to work to build something to benefit the whole country. It's the same thing this time around. The people, the area, and the country will prosper over time as this will be very good for the economy as a whole.

Which brings us back to the Fed and whether it will raise rates another 25 basis points to 4.00% in November or December. Again, we started this march to higher rates 14 months ago with funds at 1.00% and a steep yield curve. Here we are today with a flat curve of only 50 basis points from funds to the 10-year. The bond market says inflation is tame but the huge deficits going forward are of concern and we will look for the Fed to bump rates at least one more time this year. As for oil, when the price of crude starts whipping around by $4 in one day, like a garden hose, it's near the end of a parabolic move to higher prices. In sum, we believe the economy is solid, the banking industry healthy, and the Utility Index says it all.