By Joseph A. Harrison, CFA, Partner

After three years of one unfavorable economic surprise after another, the fourth quarter of 2003 witnessed a dramatic positive swing.

In October, a report of the nation’s GDP concluded that the economy had grown a robust 8.2%—the strongest quarterly gain in nineteen years. All forces that would normally have come into play much earlier had remained harnessed by tensions surrounding the war in Iraq.

Tax cuts that began in July may have been the final lever to release pent-up inventory and capital spending. Strong consumer spending and residential construction activity that had been supported with mortgage refinancing also continued. A ten-point surge in November’s Consumer Confidence Index reflected a change in public attitude. The Federal Reserve Board also maintained its low interest rate posture and predicted no immediate change.

Ongoing debates

Many argue that current rates are far too low, given the current pace of the economy and indications of price pressures. Others argue that the explosion in commodity and gold prices reflects the significant weakness in the dollar, noting that in terms of most foreign currencies, gold and commodity prices are steady.

A further argument is that deflation, with its adverse implications for debt repayment, is a greater risk than inflation and requires a longer period of low interest rates. We believe rates will move up in the first half of the year to a level consistent with strong economic gains in the 4% range. We expect short rates near 3% and a 10-year U.S. Treasury rate approaching 5% by next fall.

Bright outlook

The first half of 2004 will benefit from an expected large increase in tax refunds. Employment growth, continuing business investment in capital goods and inventories, further productivity advances, and strong profitability are in place to secure sustained economic growth. The risk of inflation is greater than deflation.