Inflation has picked up a bit, but remains remarkably subdued this late into what is now the longest economic expansion in modern history. Worldwide markets, technology-aided productivity growth and constant attention to costs have restrained price increases, but there is concern about rising wage pressures as the expansion continues.

Higher rates and energy costs will have some effect, but eventually the Fed may have to hit the brakes hard enough -- with additional short-term interest rate increases -- to impact the stock market. The main driving forces in consumer confidence now are the market and the plentiful availability of jobs. The powerful stock market rise, especially in technology-related names, continues to boost consumer confidence and spending.

Investment implications
The Fed wants to head off potential overheating in the economy to avoid a recession. They would also like to cool off speculation or "irrational exuberance" in the stock market to avoid a more serious market decline. Fine-tuning is never easy due to lead and lag times in the impact on the economy of Fed actions, but they would rather be early than too late.

Just as the economic expansion has been of historic proportion, so was the stock market advance, with a record number of consecutive 20 percent plus years. Slowing the rate of gain to a more sustainable pace would be healthy for the longevity of both the economy and the market. Investor expectations about future returns have already risen to unrealistic levels, and several years of more normal returns would also be healthy.

The stock market
For the most part the problem of overvaluation is confined to the technology/telecommunication equipment/Internet-related sector for the market. The market has been extremely narrow and two-tiered with the tech sector enjoying extraordinary valuations and investor interest, and the rest of the market in a correction and mostly ignored.

The popular averages are now dominated by the big capitalization technology stocks, which should be impacted more by any market decline than the lower tier of stocks -- many of which have already experienced bear market type declines. If the upper tier corrects as expected, the rest of the market won't escape some impact, but should be cushioned by more reasonable valuations of still growing earnings.

The bond market
The bond market experienced a very difficult year in 1999 as investor concerns about potential inflationary pressures pushed interest rates higher. Recently, the market has stabilized and bonds now appear more attractive based on the economic outlook.

With growth expected to slow, the Federal Reserve actively pursuing a more stringent monetary policy and the federal deficit continuing to decline, the outlook for the bond market is improving. Future Fed actions to raise short-term rates may have some short-term negative impact, but bond investors should be reassured about the longer term.

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