Latest Fed statement seems at odds with strong U.S. economic growth.

Full speed ahead! That seemed to be the message the U.S. Commerce Department was delivering on Oct. 30 when it announced that the American economy grew by a startling 7.2% in the third quarter, the biggest three-month spurt in almost 20 years. By contrast, the Canadian economy lost ground in August and third quarter figures are expected to come in around 2.5%.

But just 48 hours before the Commerce release, the U.S. Federal Reserve Board was still flashing caution lights when it issued a statement saying that it would keep the key federal funds rate at 1%. Moreover, the governors signalled that rates are likely to stay low for some time with the comment: “The [Open Market] Committee believes that policy accommodation can be maintained for a considerable period.”

The Fed also reiterated its view that “the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal” and continued to warn that the possibility of disinflation, “though minor”, outweighs that of higher inflation in the coming months.

What are we to make of all this? Obviously, the Fed must have had knowledge of the robust third quarter numbers before releasing its statement, yet no reference was made to it. The closest the governors came was to acknowledge the “robust underlying growth in productivity” and to say that spending is “firming” and the U.S. labour market “stabilizing”.

The logical conclusion to draw is that the Fed sees the third quarter numbers as an aberration and not sustainable. And, on closer inspection, that makes a lot of sense. A number of one-time factors contributed to the third quarter surge, including tax refund cheques and an unprecedented level of mortgage refinancings that put billions of dollars into the hands of consumers. The devaluation of the U.S. dollar also helped by increasing export sales.

One economist was quoted as saying “pop the Champagne corks” after the GDP numbers came out, but the reaction of the stock markets was much more muted with both the S&P 500 and the Nasdaq Composite posting small losses on Thursday while the Dow had a tiny gain.

I don’t think it is time to pop the corks just yet, and neither does the Fed. The GDP numbers are a positive signs, but a 7.2% growth rate is unsustainable over a longer term. Rather, what we need to see are several quarters of expansion at a sustainable rate in the 3%+ range. That is certainly feasible, given the momentum now under way and the fact we are coming into a presidential election year. But it is not a given, and there are still potential obstacles ahead.

The stock markets, which are always seen as leading economic indicators, have been telling us for some time that the U.S. recovery is real. To date, the Dow is up 17.5% for 2003, the S&P 500 has added 19.4%, while Nasdaq has surged 44.7%. Even October, which is historically a dismal month for the markets, produced substantial gains in all the major American indexes. If we use the stock market as a barometer, that suggests continued growth through the first half of 2004 at least.

However, at some point the markets are going to pause for breath, robust economy or not. The current rally has gone on almost non-stop since early March. There have been some temporary dips along the way, but if you look at the charts of the three major U.S. indexes, all show almost exactly the same ascending pattern over the past 7-1/2 months.

The danger at this point is that investors who have been sitting on the sidelines in cash, earning minimal interest, will decide that it is time to jump in with both feet. When the pull-back comes, which it inevitably will, the traumatic memories of the bear market may come flooding back and panic them into jumping right back out again.

If you have been holding a lot of cash waiting to re-enter, the best strategy at this point is to move gradually. Choose your stocks with care, pick a target entry point, and be patient. As Internet Wealth Building contributing Irwin Michael says in his latest column, “the pickings are slim with most of the low-hanging fruit already discovered.”

So wait for the right opportunity and don’t rush. If the U.S. economic recovery is real, we have a lot of upside potential still to come.