The cumulative impact of the Federal Reserve’s two-year campaign of raising short-term interest rates, from June 2004 through June 2006, is emerging in the pattern of growth in the U.S. economy. Gross domestic product grew at an annualized rate of 5.6% in the first quarter of 2006, but only 2.5% in the second quarter, according to preliminary readings. This partly reflects weaker housing activity and moderation in consumer spending. On the plus side, business capital spending is on a firm growth track, and export performance has been robust.

     Inflation

     In recent months, Federal Reserve officials have expressed concerns that inflation has risen above their comfort zone, generally believed to be 1% to 2% per year. The core consumer price index, which excludes food and energy, rose at a 3.6% annual rate in the second quarter, lifting year-to-year inflation to 2.6% from 2.1% in March. The recent increase in core consumer inflation coincides with rising import prices and broad-based pressure on unit input costs including labor, energy and other materials, and energy-intensive business services.

  Job Market

     Job growth as measured in the Labor Department’s survey of households has been strong, while labor force growth has been sluggish, sustaining downward pressure on the unemployment rate. The second-quarter slowdown in job growth as measured by the Labor Department’s survey of business payrolls (the monthly average was 108,000) is part cyclical, part payback for relatively strong gains in the first quarter (the monthly average was 176,000), and part response to interest rate and gas price increases. In July, the unemployment rate edged up to 4.8% from a cyclical low of 4.6%.

      Monetary Policy

The Federal Reserve raised the fed funds target rate from 5.00% to 5.25% on June 29 and indicated that higher inflation, not a shortfall of economic growth, remains the primary risk in the outlook. However, central bank officials also indicated that recently elevated inflation readings do not necessarily require an aggressive monetary policy response if economic data point to moderating growth that would lead to a reduction of inflation pressures. Indeed, the central bank paused in its monetary tightening efforts by keeping the fed funds rate steady on August 8 because Fed officials believe inflation pressures seem likely to moderate over time.?

Sources of data: Bureau of Economic Analysis, Bureau of Labor Statistics, Federal Reserve Board, Haver Analytics, T. Rowe Price calculations.

     http://www.troweprice.com/ August 9, 2006