Nevertheless, we think the upward trend in the Funds rate will resume possibly as early as the October FOMC meeting, as inflation continues to worsen accompanied by the likelihood of a notable dollar correction. The decision to pause could present a challenge to the FOMC. Since financial markets are prone to drastic mood swings, the Fed’s decision to pause could be interpreted by the markets as saying that inflation is no longer a threat. But, if the Fed then resumes the upward adjustments to the Funds rate, a perfectly normal thing to do, the markets would have a hissing fit. We think it makes sense for the FOMC to pause and reflect on where the economy stands now, and hopefully gain greater appreciation of the growing threat posed by our gaping external deficit and its implications for monetary policy. Also, the Fed needs to validate whether indeed the economic expansion has passed a point of inflection.

The Fed only controls short-term interest rates, and the jury is still out on how to achieve a normal tilt in the yield curve. We think that accelerating inflation, aggravated by a fall in the value of the dollar, will bump up the long end of the yield curve during the second half of this year. We also think that the 20 year bond will breach the 6.00 percent mark this year and decline moderately in 2007. One of the key risks to this forecasts is a jump in oil prices to $110 per barrel or higher for a sustainable period.

Instead of diagnosing every bit of Fed speak for hidden signals of future FOMC actions, we think it is more productive to focus on actual market data and their implications for sensible monetary policy. Trying to read the FOMC’ mind implies that Fed officials have perfect foresight. After all, they are only human, although smarter than most.

Fed officials are worried that their measure of inflation is accelerating. As we have explained in previous briefings, the Personal Consumption Expenditures (PCE) deflator ex-food and energy simply lags the CPI, which means that eventually it will overstate inflation relative to the CPI. In recent statements, Fed officials have admitted that studies on the pass-through of energy prices, or the presumed lack thereof, had failed to explain the recent runup in inflation. In asserting that "long-term" inflation expectations are "contained" the Fed is also relying on strong growth in non-farm business productivity, but we don’t see the data showing any acceleration in productivity growth. Productivity in the non-farm business sector has been slowing since the fourth quarter of 2004.

We were also intrigued by the new twist to the moving definition of inflation. In his semi-annual monetary policy report to Congress Mr. Bernanke referred to the rise in imputed-rent on owner-occupied homes as contributing to higher inflation, which has led some analysts to conclude that the imputed-rent component of the index is artificially contributing to higher inflation. You guessed it, the newly improved definition of "core" inflation will now become the PCE deflator excluding food, energy, and housing expenses! Is there anything else we spend our money on that could be used to measure "inflation"?

Fed officials have also made reference to lower inflation expectations based on the inflation-indexed U.S. Treasury bonds. However, we understand that the inflation rate used to index the bonds is the CPI and not the PCE deflator ex-food and energy. Therefore, we are not sure why Fed officials are referring to that index since, in their view, the CPI does not accurately measure inflation. On the other hand, our calculations show that the implied inflation expectations based on the 10 year indexed bonds have actually trended up moderately since mid-2005.

Our moving average measure of inflation is expected to reach 4.0 percent by the end of this year, compared to a 12 month rate of 5.0 percent expected by December. While unit labor costs are not exerting pressures on production costs, non-labor unit costs are running at a trend rate of 5.2 percent. We also expect labor compensation to move up more quickly particularly in those sectors experiencing a shortage of labor. The University of Michigan’s measure of consumer inflation expectations remains at about 3.3 percent.

We were very surprised to note an absence of any reference to the U.S. dollar in Mr. B’s prepared text for his semi-annual monetary policy testimony to Congress. While he noted that monetary policy makers "operate in an environment of uncertainty," there was no explanation of which factors the Fed considers more risky. It appears that the dollar is not considered as relevant to the economic outlook by our central bank. We are disappointed by the lack of concern over the value of the dollar shown by our policy makers in Washington. As we have repeated in previous briefings, we think a sizeable depreciation in the value of the dollar, which could materialize before the end of this year, is one of the biggest risk factors to interest rates and the economy.

We expect GDP growth to average 3.6 percent this year, followed by a more noticeable slowdown in 2007. We think that the economy is slowing, but not enough to cool off inflationary pressures. It is easy to predict a slower GDP growth rate in the second quarter given the first quarter’s unusually strong 5.6 percent rate. Industrial production has been gradually accelerating during the first half of this year and the momentum may persist into the second half.

The appointment of Mr. Henry Paulson brings an individual with a very big reputation in Wall Street to the critical post of principal economic policy spokesman. This will help to bring back some of the economic policy spotlight to the Treasury. We think Mr. Paulson will exert a positive influence on financial markets and may be helpful in manning the ship when the drop in the value of the dollar begins to rattle the markets. However, his bigger challenge will be in the budget arena, where he is at a disadvantage in tackling an unruly Congress, and where budget accounting is not always based on GAAP.

Industries that are expected to benefit from the free trade agreement include those already operating in the free zones, as well as agro-industrial firms and tourism. Studies of the economic impact from CAFTA-DR also predict that member countries will experience an increase in the size of their middle class to 40 percent of total households from the current 20 percent by the year 2020. In order to reap those benefits, the CAFTA-DR nations need to improve competitiveness, streamline customs procedures, improve seaports, airports and roads and enhance their educational system. At the same time, they also face stiff competition from China and other Asian countries.

The regional autonomy issue, also part of the referendum, won decisively in the four most important economic regions of the country: Santa Cruz, Beni, Pando and Tarija. According to a previous agreement, those regions that voted for autonomy would receive it, while the ones that rejected it would not. However, Vice-President Alvaro Garcia Linera seems to be reneging on that agreement by saying that since a majority of voters rejected the regional autonomy countrywide, the Constitutional Assembly should not consider the issue. His comments, were met with street demonstrations in favor of regional autonomy in those provinces that voted for it. In a true democracy, the Constitutional Assembly is a sovereign entity that should set its own agenda and make decisions without the interference of outsiders. It would be arbitrary for the government to backtrack on previous agreements and to dictate an agenda to the Constitutional Assembly.

The composition of the Mexican Congress leaves the three main parties with almost equal representation, although the governing PAN obtained slightly more seats in both Houses. The new president will be in the same position as President Fox, who has encountered persistent obstacles in pushing his agenda through a reluctant Congress.