Gross Domestic Product
Following zero growth in 2008 and a 2.6% contraction in 2009, real gross domestic product (GDP) increased by roughly 2.8% (an an annual basis) according to advance estimatesi released by the Bureau of Economic Analysis (BEA). The economy remained modestly expansionary in 2010 with first and second quarter changes in real GDP of 3.7% and 1.7%. These figures follow an increase in real GDP of 5% in the fourth quarter 2009. Third and fourth quarter real GDP increased by 2.6% and 3.2%, respectively, showing a slight upward trend in economic activity. While the trend in 2009 was clearly marked by recession followed by a modest upturn in activity, economic activity in 2010 could be characterized as modest. However, in 2010, housing markets remained weak with continued declines in prices and increases in foreclosures, credit markets remained tight, inflationary pressures increased and unemployment remained high.

Highlights from the GDP report include the following:

• Real personal consumption expenditures, which declined in 2009 by 1.2% and by 0.3% in 2008, increased 1.8% for 2010.
• Nonresidential fixed investment declined 17.1% on a year-over-year basis in 2009 but increased by roughly 5.5% for 2010 an annual basis.
• Residential fixed investment continued to drag on the economy with a year-over-year decline of 3% in 2010 as compared to declines of 22.9% in 2009 and 24% in 2008.
• Real exports of goods and services declined by 9.5% in 2009 but increased by over 11% in 2010. Real imports of goods and services also contracted in 2009 by 13.8% but increased by nearly 13% in 2010.
• Real government consumption expenditures and gross investment continued its expansion in 2010 with an increase of over 1% as compared to an annual increase of 1.6% in 2009.

The Federal Reserve
The Federal Reserve’s Federal Open Market Committee (FOMC) continued its overly accommodative monetary policy, which was originally instituted in 2008 following the crisis in the credit markets. The federal funds rate remained at virtually 0% for 2010. At the beginning of the year, the FOMC continued to believe that weak economic conditions warranted the exceptionally accommodative policy for an extended period of time and further justified on-going quantitative easing measures. Interestingly, Thomas M. Hoenig, a voting member of the FOMC, dissented at each meeting regarding the policy actions of the FOMC, believing further asset purchases under quantitative easing and expectations of low interest rates for an extended period were not warranted in light of generally improving economic data.

In its press release associated with its December 14, 2010 meeting, the FOMC indicated the following:
Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment. Household spending is increasing at a moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. The housing sector continues to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have continued to trend downward…

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate…the Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period….

Voting against the policy was Thomas M. Hoenig. In light of the improving economy, Mr. Hoenig was concerned that a continued high level of monetary accommodation would increase the risks of future economic and financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.

As in our last assessment, we believe that the impact of the continued correction in the housing markets has yet to be fully felt in the economy. The quantitative easing programmes (which we have opposed) of the Federal Reserve were intended to stabilize financial markets by providing additional liquidity. We continue to believe that the massive amounts of liquidity through these asset purchases and open market operations have created risks that far outweigh the stated benefits. We believe there is a high probability that the massive amounts of liquidity placed in the markets through operations at the Federal Reserve will result in dangerously destabilizing rises in inflation and further financial imbalances in the future.

Other Highlights
The consumer price index (CPI)ⁱⁱ rose 1.5% at a seasonally adjusted annual rate for the twelve months ending December 2010 as compared to a 2.7% increase for the same period 2009. The downturn was due largely to a less rapid rise in gasoline prices 13.8% increase in 2010 as compared to 54% in 2009). The food index rose by 1.5% in 2010 as compared to a 0.5% decline in 2009. The energy index increased 7.7% in 2010 as compared to a 18.2% increase in 2009. For 2009, the core CPI (all items less food and energy) rose 1.8%; for 2010, the increase was 0.8%. For 2008, the core CPI increased 1.8%. It is interesting to note that, based on the CPI inflation figures for the full years 2009 and 2010, real interest rates as measured by the federal funds rates (target range 0-¼%) remain negativeⁱⁱⁱ.

Unemployment remained elevated in 2010, though the headline unemployment number dropped from 9.9% at the beginning of the year to 9.4% by the end of the yeariv. As of December 2010, there were an estimated 14.5 million individuals unemployed. At the end of 2009, roughly 40% of the 15.4 million unemployed (6.1 million) had been unemployed for at least twenty-seven weeks. At the end of 2010, roughly 44% or 6.4 million of those unemployed had been unemployed for at least twenty-seven weeks.

West Texas Intermediate (WTI) oil prices, which rose steadily over the course of 2009, continued a gradual increase in 2010. By the end of the first quarter, oil prices had risen to from roughly $74 to over $81 per barrel. Prices remained in the $70-80 per barrel range during the second quarter, during which economic activity had slowed somewhat from the first quarter. Prices remained stable in that range in the third quarter. By the end of the fourth quarter, prices once again began to rise, ending the year at roughly $90 per barrel. The steady rise in prices, however, is still far below oil’s 2008 peak of nearly $150 per barrel in the middle of the summer. OPEC decided at its 158th Extraordinary Meeting in Quito, Ecuador on December 11th 2010 to maintain its production levels with no changes. The conference noted that the outlook for 2011 suggested the increase in the average annual oil demand would likely fall in 2011. However, demand growth was also likely to be impacted by challenging risks to the fragile global economic recovery^v.

It is likely that energy prices will remain at recent levels or higher well into 2011. It remains to be seen if current prices have found equilibrium with economic growth at continued low levels globally or if recent prices will further constrict world demand for goods and services. Overall, the risks to economic activity stemming from energy prices seem balanced for the coming quarters. However, any supply disruptions in the Middle East or fears of supply disruptions could result in a rapid rise in prices, which would have a significant negative impact upon the fragile pace of economic activity.

Economic Outlook
Economic growth was tepid in 2010. We believe economic activity is likely to be subdued in 2011. We believe the risks to the economy remain weighted towards continued weak economic activity in the coming quarters with the preponderance of evidence pointing towards sustained high unemployment, higher energy prices, and the risk of rising inflationary pressures. We have not ruled out the possibility that the economy may slide back into recession. We believe the higher probability is for stagflation—low or no growth and higher inflation.

Our assessment and expectations for the economy include the following:

• Real estate activity will continue at a similar pace in the year ahead. As a result of the unavailability of financing and the need to liquidate properties, real estate prices are likely to continue to adjust more towards fundamental valuations. We would expect a general decline in values of up to 10%.
• Oil prices (WTI) are likely to fluctuate in the $80-$100 per barrel range, possibly rising above the upper end of this range during the second quarter and the summer driving season. Should the unrest in Tunisia spread to other oil producing nations in North Africa or the Middle East, oil prices could rise rapidly, putting the brakes on economic growth.
• Inflation is likely to increase in 2010 with the core CPI increasing by roughly 2%.
• We anticipate real GDP growth of 1% – 2% for the full year 2011. It is likely that first quarter growth will be modest, but we expect a gradual weakening during the latter part of the year.
• The federal funds rate will likely remain at low levels. The pace of economic activity and any acceleration in inflationary pressures will ultimately determine the timing of the FOMC’s tightening of monetary policy. The federal funds rate will end the year under 1%.
• Unemployment is likely to fall slightly, though we expect it will remain in the 9%-10% range for 2011.

Conclusion
Based on our assessment of the state of the economy in the fourth quarter of 2010, conditions, while seeming to improve, are likely to remain largely uninspiring for economic activity for much of 2011. As such, the risks are weighted more towards subdued economic growth accompanied by more evident increases in inflationary pressures and continued high unemployment.

i The BEA GDP press releases state the following with respect to advance estimates: The Bureau emphasized that…“advance” estimates are based on source data that are incomplete or subject to further revision by the source agency.
ii Based on data from the Consumer Price Index press releases by the Bureau of Labor Statistics, United States Department of Labor.
iii The 1, 2, and 3-year Treasury rates are also below the inflation rate, implying negative real rates.
iv Bureau of Labor Statistics, United States Department of Labor, The Employment Situation press release.
v OPEC press release following the 158th (Extraordinary) Meeting of the OPEC Conference in Quito, Ecuador on December 11, 2010.