What will the Fed say about growth?

By Lucia Mutikani

WASHINGTON (Reuters) - The U.S. economy has slowed in recent months, but underlying inflation pressures are rising. How will the Federal Reserve respond?

With the global data calendar light this week, that is the key question many will want answered by policymakers at the U.S. central bank after they meet on Tuesday and Wednesday.

Since their last meeting in April, U.S. economic data has taken a decisively weak tone. But at the same time, there is no evidence that things are falling apart.

"The key questions will be about how the Fed views the present combination of weak growth and higher-than-expected inflation," said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts.

"Does the Fed still expect growth to pick up after a soft first half? Is it still confident that the upward creep in core inflation will be contained?"

Culprits for the weakness in the U.S. economy abound. First it was bad winter weather; then the so-called Arab spring, which pushed up gasoline prices; and finally Japan's earthquake and tsunami, whose disruptive effect on manufacturing surprised economists with its virulence.

Employment stumbled in May and manufacturing braked sharply, while a pick-up in core inflation gathered speed.

But on the other side of the coin, factors that hampered growth are loosening up.

"The Fed is going to acknowledge that the economy slipped into a soft patch, but they will argue for some reacceleration of activity in the second half of the year," said Christopher Probyn, chief economist at State Street Global Advisors in Boston.

The U.S. central bank is expected to confirm its $600 billion government bond-buying program will conclude at the end of the month, as scheduled. The Fed, which has been criticized for risking inflation, has set the bar very high for any more monetary stimulus.

While core inflation is rising, motor vehicle shortages bear part of the blame, and the increase is not yet seen as a threat to the economy. At the same time, the overall inflation picture is improving as gasoline prices retreat.

GROWTH FORECASTS TRIMMED

Signs of economic slowdown have also been evident in other advanced economies. On Friday, the International Monetary Fund warned of threats to world growth, citing the euro zone debt crisis and signs of overheating in emerging market economies.

It trimmed its forecast for 2011 U.S. growth but raised its euro zone projection. But even in Europe, sentiment is souring due to the troubling sovereign debt crisis.

A survey on Friday is expected to show a dip in business confidence in Germany, with the Ifo business climate index forecast to slip to 113.5 in June from 114.2 the prior month.

"They're buying time so that when the (debt) restructuring occurs, the contagion will be contained, because the core governments themselves would be holding the bonds and the banks would have time to build up earnings and create a capital cushion," said State Street's Probyn.

U.S. data due this week will likely underscore the current bout of weakness. But it should also suggest forecasts of a turnaround in the second half of the year remain on track.

A report on Tuesday is expected to show sales of previously owned U.S. homes declined in May, in part the result of tornadoes and floods that slammed large parts of the country.

But economists expect orders for long-lasting goods, a gauge of business spending, to have rebounded in May. That report, due on Friday, would be a welcome sign after a series of reports that suggested manufacturing was faltering.

"We are planting the seeds for much firmer activity in the second half," said Anthony Chan, chief economist JPMorgan Private Wealth Management in New York.

If only the job market would follow.

Weekly data on jobless benefit claims on Thursday could shed clues on whether employment improved in June after the economy added a disappointing 54,000 jobs last month.

The claims data covers the survey period for the June employment report, due early next month. Economists expect first-time applications for state unemployment benefits were little changed at 414,000 in the week ended June 18.

(Reporting by Lucia Mutikani; Editing by Dan Grebler)