On November 20, 2007 I had a conversation with Dr. David M. Jones. You may know him as the “Fed Watcher” on CNBC and CNN. His opinions regarding the Federal Reserve and the economy are widely sought out, especially in these times of financial turmoil. Dr. Jones is the President of DMJ Advisors, a Denver based consulting firm, and was a former Chairman and Chief Economist for Aubrey G. Langston & Company. He also currently serves as Chairman of Investors’ Security Trust Company in Fort Myers. In full disclosure I sit on the board of directors of Investors’ Security Trust Company with Dr. Jones. The following are excerpts from our conversation:

CRH: Thank you for speaking with me today, Dr. Jones. My first question involves the Fed and its new Chairman. How do you think Barnanke is doing?

DMJ: I give Barnanke a Grade B in contrast with Alan Greenspan who was an A. Bernanke is too academic in his approach to his policy and suffers from a lack of experience in the financial markets. It’s particularly difficult when we’re dealing with a financial crisis like what we are in right now because he does not have a pipeline to those in the trenches with the credit problem. He’s taken the right measures, but he tends to be behind the curve.

CRH: Is inflation our biggest worry? Is the fall of the dollar?

DMJ: If we look at the balance of risks – I believe that downside risks to the economy outweigh the risks associated with inflation. Inflation brings with it higher oil prices and commodity prices – and, of course the declining dollar. But the offset to that is a profoundly deflationary effect of the tightening credit market conditions. So I believe that the economic effect of too high interest rates outweighs the problems that lower interest rates and inflation brings to the economy as a whole.

CRH: So why are the markets still fluctuating so wildly?

DMJ: The Fed is having communication problems – they are saying that they have done enough loosening for now. I feel that they need to cut interest rates more than they have. You have a lot of uncertainty. 

CRH: Have we past the worst of our crisis effecting the banking and financial stocks like Citigroup and Merrill Lynch?

DMJ: Goldman downgraded Citigroup last week and this was a shock. We may only be in the fourth or fifth inning of the baseball game. More write offs may follow in the financial sector. This may further pull down the economy. I think that we can avoid a recession but just barely. Growth is only going to be 1% or so when our speed limit is closer to 3%. I don’t think we’ll have two consecutive quarters of decline (the definition of a recession), but we may come close.

CRH: The Southwest Florida market has been hit particularly hard by the credit crisis with our dependence upon growth and building. What do you see in our future?

DMJ: Hardest hit was Florida, including Miami, Fort Lauderdale and the Southwest Florida market. Southern California was hit hard as well, and Nevada. Few regions hit harder than Florida. I was making a breakfast speech to a financial group in Naples and one woman who has been around for 25 years in our area said that we usually bounce back before the rest of the nation, but this time it seems we may take longer to recover. I agree. It might be three years before the demand for housing comes close to the supply that we already have out there on the market.

CRH: What do you say to retirees relying on income investments with the current interest rate and market conditions?

DMJ: There are several issues that people need to keep an eye on and worry about with their financial portfolio. First thing is that they need to have a financial team that can identify whether their fixed income assets are of highest quality. Many are not, and with the write downs that will and are happening, someone who thought that they were in safe investments might find that their portfolio may lose value. Same holds true with corporate bonds – having a knowledgeable professional who can identify which corporate bonds are of highest quality will be very important. At Investors’ Security Trust Company we have an in-house bond specialist, Kevin Pfleger, who is second to none in his knowledge and background of fixed income investments. It isn’t common for a Fort Myers based trust company to have an in-house specialist of Kevin’s pedigree and background. Even in municipals there is a quality issue. Some are not so high quality. Across the board quality is the key word in your investment portfolio on the fixed income side. On the equity side you should look at large cap stocks that have a predictable earnings flow. Nobody knows how this will end and there is a high amount of uncertainty.

CRH: You’ve never jumped on the China bandwagon. Why not?

DMJ: China is a remarkable story. But the real story is whether China has decoupled from the US economically speaking. The answer is - I don’t think so completely. Elsewhere the slowing of the US is already showing in the UK with property bubbles busting there and in Spain as well. Germany and other European countries are slowing with the strong euro versus the dollar. With Europe, the UK and US all slowing, it is unlikely that Asia, and by that I mean non-Japan Asia, can remain decoupled from the rest of the world.

CRH: What drives China, then?

DMJ: The good news from China is that they are half way through a twenty year industrialization cycle. China is rebuilding her cities and infrastructure to absorb 1 billion people migrating to the coastal cities from the rural areas, which is contributing to her growth. The authoritarian government is a problem for China. Since capital is allocated by the communist party and not by the free markets it is probably not being allocated correctly. Their financial system is quite antiquated. They have had double digit economic growth – and are in process of passing Germany as the third largest economy in the world. But I see China as a speculative bubble ready to burst. The mainland stock market is double the valuation of the Hong Kong market – which is closer to the true free market model, and that does not bode well for China as a whole.

CRH: I read a lot of gloom and doom in the financial press about the possibility of China switching her foreign exchange reserves from dollars to euros. What’s your opinion on this – problem or not?

DMJ: The Middle Eastern countries are looking at moving from dollars to euros as well. When countries do this, they always seem to do it at exactly the wrong time. They do it when the dollar hits bottom. Many Fed studies show that shifts in currency reserves has relatively little effect on the dollar. Doom and gloom scenarios are overplayed. It is true that China has $1.4 trillion of foreign exchange reserves. But if China starts selling the dollars – this would result in a further reduction of the value of the dollar, which means that they can’t do very much of it without hurting themselves. Certainly China is an important trading partner but if we slow down and Europe slows down they’re in trouble. So I don’t see China being as much of a threat as many in the financial press make her out to be.

CRH: Is the Dollar bottoming out?

DMJ: I think so. Exports get stronger with the falling dollar. European central banks are going to have to tighten further than they have. This and a variety of other factors will help the dollar stabilize.

CRH: What effect, if any, will next year’s election bring to the economy?

DMJ: I fear the timing of Democratic based tax increases. Congressman Charlie Rangel is trying to raise taxes in a disguised bill that he says helps the middle class with the Alternative Minimum Tax. The danger with Rangel and others is that if taxes are raised on corporations or investments – like an increase to the dividend or capital gains taxes, it would be dangerous for what is now a vulnerable economy. Certainly a return of high estate taxes won’t be good for our economy either.

CRH: Your forecast for economic recovery?

DMJ: I’m hopeful that in 2009 we start to see a strong recovery.