FOMC Meeting ??“ A Summary of Recent Economic Developments

The Fed is nearly certain to leave the federal funds rate unchanged at 5.25% following the June 27-28 FOMC meeting. The highlights of the inflation-growth debate have changed slightly since the May FOMC meeting. A few bullish economic numbers have altered the landscape but weakness in consumer spending and housing market woes cannot be ignored. The May policy statement noted that ???economic growth slowed in the first part of this year and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to expand at a moderate pace over coming quarters.??? The U.S. economy grew at an annual rate of only 0.6% in the first quarter, following three quarters of sub-par growth. There is a good chance for a small pickup in economic growth during the second quarter but a similar pace of economic activity is unlikely to prevail in the second-half of the year.

News from the housing market is largely grim. The reach of the housing market adjustment remains hazy. The latest fall out from closing of two hedge funds dealing with subprime mortgages is unsettling. The meltdown in the subprime sector will probably continue to exacerbate the slump in the housing market. Data for new (June 26) and existing (June 25) home sales, capital spending, and orders of durable goods (June 27) in May will be available prior to the FOMC meeting.

A sharp drop in home prices brought about an increase in sales of new homes in April, while existing home sales fell in April. Sales of new and existing homes were down 8.2% from a year ago in April. There is a deceleration in the pace of decline of home purchases but the bottom is probably not here yet.

Capital spending is also on the watch list among other critical economic indicators. Equipment and software outlays rose at an annual rate of only 2.0% in the first quarter after posting declines in the second and fourth quarters of 2006.

Comments on inflation are the other important aspect of the policy statement. The Fed??™s hawkish remarks about core inflation in the May policy statement ran as follows: ???Core inflation remains somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.??? Although overall inflation was up sharply in May (+0.7%), the core CPI moved up only 0.1%. The year-to-year change in the core CPI in May was 2.24%, a noticeable deceleration from a high of 2.93% in September 2006. The year-to-year change in the core personal consumption expenditure index excluding food and energy, the Fed??™s preferred price measure, was 2.0% in April, down from a high of 2.44% in August 2006.

The unemployment rate has held between 4.4% and 4.6% for nine straight months, which is troubling for the FOMC. Historically, the jobless rate moves in a narrow range for several months just prior to a recession before posting gains. The good news here is that the low unemployment rate has not translated into bothersome wage gains. Hourly earnings appear to have peaked (see chart 5). Other measures of labor compensation -- Employment Cost Index and compensation from the productivity report -- do not signal wage pressures consistent with the low unemployment rate (see chart 6).

At the same time, the operating rate of the factory sector has declined to 79.9 in May from a high of 81.1 in August 2006. All said, resource utilization in the factory sector appears to be less of an issue compared with a few months ago.

Inflation expectations (see chart 8) have risen in 2007 compared with the situation in late 2006. However, the current reading is nearly 30 bps below the high of 2006 when the Fed was raising the federal funds rate and energy prices were higher than quotes of recent days (see chart 9).

In sum, core inflation has decelerated but the Fed needs additional evidence of weak economic growth to consider a change in monetary policy.