(Corrects typographical error in the 12th paragraph.)

June 26 (Bloomberg) -- When Federal Reserve policy makers meet later this week, they will be faced with two different and conflicting sets of expectations.

The first set relates to market expectations for further interest-rate increases: one at the conclusion of Thursday's meeting, another at the subsequent get-together on Aug. 8, and a slight possibility of a third on Sept. 20. The second has to do with where the economy will be in six to 12 months.

The federal funds futures market sees a June 29 rate increase as a done-deal-plus: At 5.28 percent, the implied yield on the July fed funds futures contract suggests a small chance of a 50-basis-point move.

The odds of an August increase to 5.5 percent have risen to 92 percent from 0 percent as recently as June 5, a response to rising inflation and comments from Federal Reserve officials on its unwelcome nature.

Out there in the real world, there are signs of slower economic growth, specifically in housing and consumer spending. Employment growth has downshifted in the last three months to an average of 125,000 a month compared with 166,000 in the December to February period. Broad money growth -- for the handful of people who still think it matters -- has become an oxymoron: M2 has shown no growth in the last eight weeks. (Yes, inflation is a monetary phenomenon, something that gets lost in the discussion of its symptoms, such as raw materials prices and wages.)

More important is what leading indicators are suggesting about future growth prospects. Last week, the Conference Board reported that its Index of Leading Economic Indicators fell 0.6 percent in May, the third decline in four months.

Negative Territory

That wasn't the bad part. While the notion of three consecutive monthly declines in the LEI as a harbinger of recession lingers, the business cycle gurus at the Conference Board don't focus on it. They claim the six-month diffusion index and six-month annualized change do a better job of forecasting turns in the economy.

The six-month diffusion index, which measures the number of components that are rising over that time span, fell to 50 in May. That's exactly where it was a year ago, with seemingly no untoward consequences.

The six-month annualized change in the index turned negative for the first time since 2001 in May. The 0.4 percent decline isn't in itself a cause for alarm; not every breach of the zero barrier has resulted in recession (1984 and 1995).

But it is an extension of a softening trend that has taken the six-month change from a high of 10.8 percent in July 2003 to -0.4 percent now and augurs slower growth ahead.

So if the Fed is looking to take the edge off economic growth and the heat off inflation, it should consider the LEI's warning.

We're All Hawks

``To anyone who's been following the LEI, it's not much of a surprise,'' says Ataman Ozyildirim, an economist with the Conference Board's business cycle indicators group. ``It's not signaling recession, but we're not in a strong expansionary period. The level of the index is below November's.''

The pause in the campaign to normalize short-term rates that Fed Chairman Ben Bernanke suggested in April is now a fond memory. One by one Fed officials have picked up the inflation- fighting gauntlet, reinforcing the bond market's distaste for dovish talk and resistance to an end to the tightening cycle.

And we would have it no differently. Fed officials are supposed to be hawkish on keeping inflation in check. The whole issue of dove and hawk is a moot point nowadays because central bankers around the globe agree that price stability is the most important ingredient for growth. They know they can't get more growth out of an economy that is up against its capacity constraints. Europe's slow growth, a reflection of its slow potential, isn't preventing the European Central Bank from raising rates.

Overshooting Guide

The question for the Fed and for other central banks is, what role should a lagging indicator like inflation play in setting policy that will have its main thrust in the future? How do policy makers know when they've done enough?

Recently Bernanke referred to the three- and six-month annualized rates of core inflation (excluding food and energy) as unwelcome developments. June's three-month annualized increase in the core consumer price index of 3.8 percent was the largest in 11 years and well above what any price-stability-touting central bank can tolerate.

So how does the Fed know when to stop? Does it wait until the CPI stops rising? Until growth collapses? Past experience suggests that no one has yet come up with a formula to prevent overshooting.

Peak Expectations

Even as expectations for the peak funds rate are rising (6 percent is the latest resting point), in some quarters expectations for growth are deteriorating.

Susan Sterne, president of Economic Analysis Associates Inc., in Greenwich, Connecticut, has overall and core inflation peaking in the second and third quarters of this year, and falling a full percentage point in the next 12 months. (Sterne's analysis uses the personal consumption expenditures price index.) That assumes the Fed stops at 5.25 percent.

The growth in real gross domestic product slows to 1 percent in the first and second quarters of 2007 in Sterne's forecast, a result of ``higher inflation and interest rates, lower housing and vehicle sales, and weakening employment, wage and wealth prospects.''

The Fed is faced with rising inflation, the result of yesterday's policies, and actual and prospective signs of slower growth. It would be nice if both sets of expectations got a hearing.

(Caroline Baum is a columnist for Bloomberg News. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: June 26, 2006 08:55 EDT