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MARKET CLOSES The Provident Bank


									   wealth management
   Volume 3 Edition 4           |   April 29, 2011

economic theme:
Monetary Policy:
“Who do you believe, me or your eyes?”
The quote, “Who do you believe, me or your eyes?” is attributed to the
comedian Groucho Marx. We are not familiar with what context
Groucho used the phrase. So, you might ask, what is the connection
between the quote and monetary policy? Well, it may qualify as a Bikram
(the Yoga teacher) stretch, but Federal Reserve officials seem to have
turned a blind eye to reality when it comes to inflation. That’s because
the Fed focuses on core inflation which excludes food and energy. As
anyone who owns a car can attest, inflation is a reality at the pump. The
Fed’s narrow focus has important monetary policy implications because,             James nesci                           alan D. Segars
if the spike in oil and other commodity prices is not “transitory” as Fed          Senior Vice President                 Vice President
Chairman Bernanke suggested in his recent press conference, then the               Chief Wealth Management Officer       Investment Management Officer

Fed will likely fall behind the curve in combating possible secondary
                                                                               We believe the decline in corporate spreads (corporate yields less
inflation effects. With this risk as a backdrop, let’s examine the likely
                                                                               Treasury yields), which is bullish for risky asset prices, will be halted. Bond
course of monetary policy based on the Fed’s core definition of inflation.
                                                                               yields could be biased upwards as major support for escalating Treasury
The Federal Reserve has two mandates affecting policy decisions:               supply is removed; inflationary expectations rise; and foreign central
1) inflation; and 2) full employment. Conveniently, we can forecast the        banks, such as China, continue dollar diversification efforts.
path of monetary policy based on our expectations of core CPI and the
                                                                               On the subject of inflationary expectations, the increase in oil and
unemployment rate. When we went through this exercise in mid-2010,
                                                                               gasoline prices has exceeded our targets and may be more persistent as
our model suggested that the Fed funds rate should be a negative 2%
                                                                               well. At a recent $3.88 average price per gallon, petrol prices have
based on an unemployment rate of 9.6% and a year-over-year core CPI
                                                                               outstripped the jump in oil. This may be primarily due to two factors:
gain of 1%. This analysis suggested to us (rightly so) that the Fed would
                                                                               1) increased purchases of higher-priced foreign oil by US refineries; and
not tighten policy until late 2011 or early 2012, especially as the funds
                                                                               2) rising refinery margins reflecting increased market uncertainty. Given
rate forecast would have to climb out of negative territory first. Our
                                                                               Middle East/North Africa conflicts and geopolitical tensions, these
updated forecast is based on expectations of an 8% unemployment rate
                                                                               factors could be in play for a while. Adding fuel to the fire, Russia, the
and a core CPI gain of 1.5%. Clearly, labor market conditions have
                                                                               world’s largest oil producer, increased petrol export prices effective
improved, and the inflation rate is accelerating. By the end of this year,
                                                                               May 1 to combat internal oil shortages.
the funds rate should be at about 0.25% versus the Fed’s current target
of 0.0%-0.25%. Consequently, Fed tightening could be a reality by the          Bottom line, the spike in energy and other commodity prices could be
first quarter of 2012. Fed funds options and futures data indicate that the    more than transitory and could produce secondary inflation effects
most likely funds rate will be 0.0% through March 2012. Thus, the timing       across a broader spectrum of consumer goods and services, ultimately
of tightening could be somewhat of a surprise to the market. The               influencing wage rates. Assuming economic growth is slowed but not
accompanying chart shows the fit between forecast results and actual           aborted by this event, the Fed would be forced to acknowledge a
Fed funds in our model.                                                        greater inflation threat and act accordingly with eyes wide open.
Given that the Fed has employed unconventional strategies, such as
asset purchases, during this easing phase, the tightening phase or exit
strategy will also have unconventional components. Bernanke
suggested in the press conference that the initial move could be not
reinvesting securities repayments. Other possibilities include selling
securities from the Fed’s portfolio; increasing the rate of interest paid to
banks on reserves; and traditional hiking of the Fed funds rate. Bernanke
also confirmed an end to QE2 on June 30. This so-called Quantitative
Easing program absorbed about 70% of Treasury bond issuance since
late last year. The program has been successful in elevating risky asset
(stocks, commodities, etc.) prices and keeping bond yields stable. While
its demise appears certain, the impact on the capital markets is less so.
       On April 13 we adapted a neutral weighting for domestic and international equities, which were previously 3% overweight versus the
       Provident Target Asset Allocation Benchmark. As indicated above, the liquidity-induced positive environment for risky assets will likely be
       muted by monetary constraints compounded by fiscal measures. Corporate bond spreads, typically bullish for risky assets, have probably
       bottomed in our opinion. Upside earnings surprises have recently taken broader market indexes to multi-year highs. Our valuation price
       targets have been met, and we have no reason to raise them. The 6% in cash raised from the equity reduction was used to increase
       exposure to short-term credit (CSJ), domestic real return bonds (IPE) and a new asset class, REITs (VNQ). We remain underweight domestic
       bonds and overweight alternative investments.

                                                                                          MARKET CLOSES
            S&P 500 Index: 1,363.61                                    Dow Jones Industrial Average: 12,810.5                                                    10-Year Treasury Yield: 3.29%

                                                                   (973) 822-0019 •
This commentary has been prepared by the Wealth Management Group of The Provident Bank for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or a solicitation of an offer to buy any
security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security or pursuing a particular investment strategy. Any opinions expressed herein reflect our best judgment as of the date of this
publication and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and
may involve general market risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. The opinions, views, and information expressed in
this commentary regarding portfolio holdings are subject to change without notice. The information provided regarding portfolio holdings is not a recommendation to buy or sell any security. Portfolio holdings are fluid and are
subject to change based on market conditions and other factors. Investors should consider their individual circumstances, investment goals, and risk tolerance prior to making an investment decision.

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