NEW YORK (CNN/Money) - The Federal Reserve gave the U.S. economy's performance in April and May a barely-passing grade Wednesday, in a report likely to solidify market expectations that an interest-rate cut is on the way.
In the Fed's periodic "beige book" report, named for the color of its cover, the twelve Fed districts reported economic activity that ranged from mediocre to so-so, defying expectations that the end of the U.S.-led war with Iraq would boost the economy.
"The unwinding of war-related concerns appears to have provided some lift to business and consumer confidence, but most reports suggested that the effect has not been dramatic," the report said.
Consumer spending was "lackluster," with retail sales still lower than they were a year ago. Manufacturing activity, which has been suffering even longer than the rest of the economy, was mixed, with some districts reporting a drop in orders and some reporting optimism.
Even the healthier service sector, which makes up about 85 percent of the total economy, was "sluggish."
And, perhaps most importantly, labor-market weakness continued, driving wages down. What's worse, companies had to pay more for employee benefits, pinching their profits.
One bright spot, as usual, was residential real estate, as super-low mortgage rates continued to spur demand for houses.
Fed policy makers are scheduled to meet on June 24 and 25 to discuss the economy and whether or not to cut their target for a key overnight lending rate, and the beige book report will guide their thinking.
"This report leaves the door open for a rate cut," said Gary Thayer, chief economist at A.G. Edwards in St. Louis. "There's still uncertainty out there, and as a way to sort of offset the uncertainty, the Fed will do more than it may need to do."
Most economists predict the economy will be stronger in the second half of the year. But many of them also think the Fed will cut rates again in June, to take out additional insurance against the prospect, however remote, of deflation, an unstoppable drop in prices that hurts corporate profits and economic growth.
The beige book report said prices were about as stagnant as the economy in April and May, "with no widespread inflationary or deflationary pressures." Prices for some services, including insurance and tuition, rose, however. Natural gas prices also rose, something Fed Chairman Alan Greenspan has warned could hinder the economy later this year.