The Fed has not been consistent in terms of how long it holds to a policy – the reference here is to equal risks for the next few quarters. For instance, when the FOMC introduced the phrase "considerable period," we counted nine months between the first use of that statement and when it stopped using the phrase, clearly nine months is not a considerable period of time. The FOMC statement also asserts that underlying inflation will remain low. Underlying inflation is another term for the buzz word "core" rate of inflation, which we have repeatedly criticized as misleading because it leaves out food and energy. To account for possible price volatility, we use a moving average of the CPI which allows for the effects of changes in food, energy and other commodities to impact the rate gradually. But the Fed also decided to use the personal consumption deflator from the national income accounts, perhaps because it shows an even lower inflation rate. Yet as we have been predicting, inflation, as measured by the standard CPI index or even the so-called "core" index, has been exceeding the Fed’s expectations, and this may explain the more forceful statement made by the FOMC that it will respond firmly to any threats against price stability. This latter statement may be a recognition within the Fed that inflation is indeed gathering some steam.

The key questions now are by how much more will the Fed raise the Funds rate and by when, and what will happen to the long end of the yield curve. We think the Fed will continue to raise the Funds rate in accordance to their "obligation to maintain price stability." This means that the FOMC could push the Funds rate up to 2.00 – 2.25 percent by the end of December. As inflation accelerates, the Funds rate could be in the range of 3.50 - 3.75 percent by the end of next year. On the long end of the yield curve, we expect the 10 year and the 20 year rates to move up to 5.00 and 5.75 percent by year end, and another 50 to 75 basis points next year.

First quarter GDP growth was recently revised to 3.9 percent, moderately lower than the 4.1 percent rate posted in the fourth quarter of last year. The pattern of growth during the past three quarters shows personal consumption expenditures on non-durable goods and on services as the drivers of the economy with business investment also gathering steam. The interest-sensitive durable goods sector has been weakening. Residential investments have also reduced their steam as a result of the recent upturn in interest rates. Nevertheless, the economic expansion appears to be on solid footing. Industrial production has been gathering strength during the past year, and as of May the index stood 6.3 percent above the same month in 2003. Rising employment, increasing personal income, still low interest rates, and improving consumer sentiment are boosting demand. New home sales jumped 14.8 percent in May. On the other hand, the unemployment rate remains at 5.6 percent, in part due to the structural problems that we have explained in previous briefings.

We think there is no one single cause for the upturn in the inflation rate. A number of analysts seem content with picking their own particular reason why inflation will or will not change, as if it were that simple. Some have concluded that the surge in oil prices is the principal determinant of the recent up-tick in inflation, but that once oil prices stabilize, inflation would no longer be a problem. Others argue that since food and energy are not part of the so-called "core" inflation, these prices will have no impact on inflation. Others reason that declining unit labor costs and the continuing surge in productivity will assure low inflation rates in the foreseeable future. We on the other hand think inflation is not just the impact of the recent surge in oil prices, which we think is real, nor purely a unit labor cost phenomenon, although productivity growth appears to be waning, but rather the combination of these variables with the recent acceleration of demand in the global economy along with other inflation factors that may pop up on the radar screen. We have persistently and consistently argued that inflation was going to accelerate as the economic expansion gathered momentum.

Higher economic growth has fanned inflationary pressures. Increasing commodity prices have been pushing up costs, which will inevitably be passed on to final goods prices. Oil prices averaged $40.28 per barrel in May, and are not expected to decline significantly during the long hot summer months. We think unit labor costs are poised for significant increases during the second half of this year. Businesses have been hiring more workers, a trend that is likely to reduce the rate of productivity growth. We think productivity growth will decline to the 2.5 percent range as employment growth picks up, and with expected increases in compensation and benefits costs, unit labor costs will thus begin to put upward pressures on prices of goods and services. Our inflation measure based on a 12 month moving average of the standard CPI index was 2.1 percent as of May, but is projected to reach 3.3 percent by December, which coincides with consumer inflation expectations reported in the latest University of Michigan consumer survey.

The latest FOMC statement makes reference to robust underlying productivity growth as assuring stable prices, but we think their statement is not accurate. The Fed’s reference to a surge in productivity growth refers only to the manufacturing sector, which during 2002 - 2004 QI, has averaged 5.6 percent per annum growth in productivity. However, manufacturing represented only 13.9 percent of GDP in 2002; and for that reason we think a more accurate measure of productivity is one based on total output in the economy. Output by non-farm businesses, which includes all sectors in the economy except agriculture, would be a more accurate basis for calculating overall productivity growth. Non-farm business productivity has averaged 2.3 percent growth during the past 56 years. Productivity growth usually accelerates during a two to three year period following a recession. We measured the average productivity growth for the period immediately following each recession since 1960 and arrived at an average non-farm business productivity growth during the initial business cycle expansion period of 3.3 percent per annum. Since the end of the 2001 recession, productivity in the non-farm sector has averaged 4.2 percent, which is higher than the 3.3 percent norm, but not unusually strong. In fact, the next highest growth period occurred following the 1960 recession, with 3.6 percent productivity growth. As we mentioned above, as employment continues to expand during the next couple of quarters, non-farm productivity growth is expected to move closer to the 2.5 percent range.

The combination of higher inflation and interest rates will put a damper on economic growth next year. However, we think there are several risk factors that could result in higher real, or inflation adjusted interest rates. With election year politics, the surge in military spending, and higher interest rates, we do not expect a significant reduction in the fiscal deficit through 2005. At the same time, structural economic problems will aggravate the hemorrhaging in the foreign trade accounts leading to greater volatility in the currency markets, and the possibility that the value of the Euro could reach US1.35. These factors could drive the risk premiums in the long-end of the yield curve to even higher levels.