The Fed’s Forecast

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The Federal Reserve today released the April 29-30 meeting minutes of its Federal Open Market Committee (http://www.federalreserve.gov/monetarypolicy/fomcminutes20080430.htm) , which sets the federal-funds rate at which banks lend reserves to one another. The Fed also released the forecast that accompanied the meeting. That was enough to clinch a brutal day on Wall Street.

Begin with the Fed’s synopsis of current conditions:

“The information reviewed at the April meeting, which included the advance data on the national income and product accounts for the first quarter, indicated that economic growth had remained weak so far this year. Labor market conditions had deteriorated further, and manufacturing activity was soft. Housing activity had continued its sharp descent, and business spending on both structures and equipment had turned down. Consumer spending had grown very slowly, and household sentiment had tumbled further. Core consumer price inflation had slowed in recent months, but overall inflation remained elevated.”

That was bad, but the projection was worse:

“The projections … suggest that FOMC participants expected economic growth to be much weaker in 2008 than last year, owing primarily to a continued contraction of housing activity, a reduction in the availability of household and business credit, and rising energy prices. The unemployment rate was expected to increase significantly. However, output growth further ahead was projected to pick up by enough to begin to reverse some of the increase in the unemployment rate by 2010. In light of the recent surge in the prices of oil and other commodities, inflation was expected to remain elevated in 2008. Inflation was projected to moderate in 2009 and 2010 as the prices of crude oil and other commodities level out and economic slack damps cost and price pressures. Most participants judged that the uncertainty around their projections for both output growth and inflation was greater than normal. Most viewed the risks to output as weighted to the downside. Participants were roughly evenly divided as to whether the risks to the inflation outlook are broadly balanced or skewed to the upside.

“The central tendency of participants' projections for real GDP growth in 2008, at 0.3 to 1.2 percent, was considerably lower than the central tendency of the projections provided in conjunction with the January FOMC meeting, which was 1.3 to 2.0 percent. Participants viewed activity as likely to be particularly weak in the first half of 2008; some rebound was anticipated in the second half of the year. Incoming data on spending and employment already indicated a softening economy this year. Real incomes were being held down by higher oil prices; falling house prices had reduced household wealth; and households and businesses were facing tighter credit conditions. Exports were seen as a notable source of strength this year owing to continued economic growth overseas and the depreciation of the dollar over the past year or so. Many participants also said that the substantial easing of monetary policy since last year and the fiscal stimulus package should help to support spending in the second half of the year.

“With output growth well below trend this year, most participants expected that the unemployment rate would move up. The central tendency of participants' projections for the average rate of unemployment in the fourth quarter of 2008 was 5.5 to 5.7 percent, above the 5.2 to 5.3 percent unemployment rate forecasted in January and consistent with significant slack in labor markets and the economy. Most participants expected the unemployment rate to edge down in 2009 and 2010.”

(The Fed also included a table that showed output lower and unemployment and inflation higher than initially forecast for both 2008 and 2009.)

Note the second-to-the-last sentence of the second paragraph in quotation marks above: “Most viewed the risks to output as weighted to the downside.”

Note, too, the third sentence before that: “However, output growth further ahead was projected to pick up by enough to begin to reverse some of the increase in the unemployment rate by 2010.”

The risks to output are weighted to the downside and the unemployment rate won’t improve until 2010.

No wonder the stock market plunged. What about the second-half 2008 economic recovery that was supposed to send earnings and stocks higher?

© 2008 Michael B. Lehmann