PRINTMarket Update -- Economic Comment
February 22, 2008
In the January 29-30 FOMC meeting minutes, participants explained that the 125 basis points reduction in the federal funds rate during January was a needed recalibration of monetary policy in response to a deteriorating economic outlook. New growth projections for 2008, supplied by participants for this FOMC meeting, showed a central tendency range of 1.3% to 2.0% compared to a range of 1.8% to 2.5% seen in October. Reasons cited for the downward revision included "a further intensification of the housing market correction, tighter credit conditions amid increased concerns about credit quality and ongoing turmoil in financial markets, and higher oil prices." The FOMC's base case is that weak economic growth in the first half of 2008 will be followed by sustained improvement in the second half of the year. In 2009, they expect real GDP growth to come in between 2.1% and 2.7%. The risks to economic growth, however, were seen as weighted to the downside meaning that their forecast could still be too high.
On the inflation front, the FOMC expects core PCE inflation to remain slightly above the 1–2% implicit target in 2008 before slipping back into the top end of that range in 2009. Improvement is expected to come from the leveling-off of energy and commodity prices, slower economic activity, and well-anchored inflation expectations. While the minutes indicated that the FOMC is concerned about inflation, concerns about growth appeared to dominate concerns about inflation.
While we would like to believe in the Fed's base case, we think they are still overly optimistic about the economy's prospects. We believe real output will contract in the first half of the year, bounce temporarily in the second half, and then slowly return to a moderate pace in 2009. While inflation is likely to prove to be a bugbear in the near term, our forecast for depressed demand should limit general price increases over the next year. Thus we too are more concerned about economic growth than inflation.
Our pessimism is due to an expectation that the credit market crisis will be a drawn out affair that restrains economic activity well into 2009 by hardening the arteries of credit creation. Moreover, we believe the housing market correction will continue for most of this year. In this environment, we expect business managers and consumers to retreat and exacerbate the downturn. In response, we expect the Fed and Washington to further loosen monetary and fiscal policy in hopes of restoring the blood flow. The good news is that there is a ton of cash sitting on the sidelines looking for the right time to step in and collect the large-sized risk premiums currently available. We expect these capital flows coupled with looser policy to keep the patient alive and help restore him to eventual health.
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