As we had predicted, the Fed has held the Funds rate at 5.25 percent and we expect the FOMC to keep the status quo at its August 7 meeting and very possibly hold the line through the end of the year, unless inflationary pressures continue to firm up. One of the reasons we do not expect a change in the August meeting is that the second quarter GDP advance estimate, which is slated for release at the end of July, is likely to show a pick up to above what is considered the economy’s potential growth rate and thus harken the Fed’s fears of rising inflation.

The final estimate of first quarter GDP growth of 0.7 percent confirmed the economy’s meager growth. The principal contributors to the weakening were the drop in residential investment, which fell at an annual rate of 15.8 percent and the decline in inventories coupled with the worsening of net exports of goods and services. On the other hand, consumer expenditures continued to forge ahead at a healthy clip of 4.2 percent.

Production and income indicators have shown some strengthening during the second quarter. Industrial production expanded at a faster rate than in the first quarter. The ISM non-manufacturing index – a measure of activity in the services sector also shows consistent expansion during the second quarter. Nevertheless, the recession in housing construction has not shown any signs of abatement.

Housing construction is the weak link in the economy. The National Association of Realtors reports that the inventory of existing homes continues to bulge, median prices are falling though moderately so far, and the index of pending home sales is showing further declines and in May stood 13.3 percent below the May 2006 level. One consolation is that mortgage interest rates remain at historically low levels.

Inflation is re-accelerating. Our moving average of the CPI was at 2.6 percent in June and we forecast the rate will reach 3.3 percent by December. On a 12 month basis, the CPI should accelerate to 5.0 percent by year-end. We think the Fed has effectively convinced market participants that inflation is only 1.0 percent, as measured by the lagging price index denoted as the PCE deflator excluding the irrelevant consumer staples of food and energy. However, as market analysts see through the limitations of the Fed’s inflation index, expectations are likely to adjust quickly with repercussions for the long end of the yield curve. The University of Michigan consumer survey shows inflation expectations of 3.4 percent in June, up from 3.0 percent in March of this year.

Another factor to consider in analyzing inflation is the globalization of consumer prices. Global demand growth is now a more important driver in the behavior of U.S. prices since consumers are more reliant on imports of goods and services from the rest of the world, and U.S. production must compete with the rest of the world for commodity inputs whose prices are determined by global markets. A weakening dollar is also compounding the effect of inflationary pressures from the rest of the world. The Fed’s own expansionist monetary policy following the onslaught of the 2001 recession may have also contributed to the bulge in the U.S. external deficit which is now leading to inflation-linked currency adjustments. In fact the Euro has recently reached US$1.38 on its way to our original forecast of US$1.55.

We think the long-end of the yield curve will continue to steepen as growth in the U.S. and the rest-of-the-world will keep pressuring inflation. Thus the 10 and 20 year bonds could move up another 40-50 basis points before the end of the year.