American pie
"As had been the case in some previous cyclical episodes, a relatively low real federal funds rate now appeared appropriate for a time to counter the factors that were restraining economic growth, including the slide in housing activity and prices, the...
"As had been the case in some previous cyclical episodes, a relatively low real federal funds rate now appeared appropriate for a time to counter the factors that were restraining economic growth, including the slide in housing activity and prices, the tightening of credit availability, and the drop in equity prices."
The sentence above, from the January 29-30 Federal Open Market Committee (FOMC) minutes, suggests that the Fed will continue to cut rates and keep Fed funds at a low level for a fairly long period. The reference to "some previous cyclical episodes" strongly hints at the recessions in the early 1990s and early 2000s, when the real Fed funds rate was negative. So without necessarily forecasting a recession, the FOMC seems to be quite aware of this possibility, which is of course now a fairly obvious possibility.
The FOMC cut its growth forecast for 2008 to sub-trend, with the low end of the range at 1 per cent, thereby suggesting that the most pessimistic forecaster's most likely path for the economy is to avoid a recession, although the uncertainty around the forecast now strongly suggests that the FOMC sees it as within the realm of statistical possibility.
Using the 70 per cent historical projection error, real GDP could be as low as 0.5 per cent in 2008, which would most likely involve two or three quarters of falling GDP. As a result, a fairly large upward revision in the unemployment rate central tendency forecast was seen, to 5.2-5.3 per cent from 4.8-4.9 per cent.
However, the inflation forecasts for both the headline and core rates were revised higher, the core rate to 2-2.2 per cent from 1.7-1.9 per cent. Therefore, the growth-inflation mix has deteriorated. And the slight upward drift in core inflation is expected to persist into 2009, with the forecast for that year also being revised a touch higher. The fact that the January core CPI rose by 0.3 per cent, bringing the year-over-year rate to 2.5 per cent, only adds to the anxiety.
We detect some light inconsistencies in the forecast. First, core inflation is set to be slightly higher still in 2009, despite unemployment in 2009 now expected to be higher too (and GDP growth a touch slower). These developments should be disinflationary but the FOMC does not see it that way, perhaps due to the recent run up in energy and food prices (the weak dollar and rising import prices were already a "known known"), although much of these forecast revisions could simply be a result of persistence from recent data surprises.
Second, real GDP is projected to rise at a touch below the implied trend in 2009 before picking to ever so slightly above it in 2010. This is apparently enough to drive the unemployment rate lower again to 4.9-5.1 per cent by the end of 2008. We believe that stronger growth in the 3 per cent-plus area will probably be required to achieve that outcome.
Finally, the pitfalls of making very long-run forecasts based on unexpected changes in the recent data are visible in this set of FOMC forecasts. Three months ago, the FOMC's unemployment forecast for the fourth quarter of 2010 was 4.7-4.9 per cent. This is meant to be an informal "long-run" estimate of where the FOMC sees the non-accelerating inflation rate of unemployment (NAIRU) and this estimate should not move very often. Yet it only took one bad payroll report (the December report) to shift this implicit NAIRU estimate to 4.9- 5.1 per cent, a rise of 0.2 percentage points.
The forecast range was even more sharp, up to 4.7-5.4 per cent from 4.6-5 per cent.
Overall, the FOMC still sees the risks to growth on the downside and although it suggests it will react to bad inflation news by being less aggressive, financial markets appear to have decided that the Fed is merely doing its duty by talking tough about price stability but will continue to ease aggressively anyway to cushion the blow of the credit crunch.
• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
The sentence above, from the January 29-30 Federal Open Market Committee (FOMC) minutes, suggests that the Fed will continue to cut rates and keep Fed funds at a low level for a fairly long period. The reference to "some previous cyclical episodes" strongly hints at the recessions in the early 1990s and early 2000s, when the real Fed funds rate was negative. So without necessarily forecasting a recession, the FOMC seems to be quite aware of this possibility, which is of course now a fairly obvious possibility.
The FOMC cut its growth forecast for 2008 to sub-trend, with the low end of the range at 1 per cent, thereby suggesting that the most pessimistic forecaster's most likely path for the economy is to avoid a recession, although the uncertainty around the forecast now strongly suggests that the FOMC sees it as within the realm of statistical possibility.
Using the 70 per cent historical projection error, real GDP could be as low as 0.5 per cent in 2008, which would most likely involve two or three quarters of falling GDP. As a result, a fairly large upward revision in the unemployment rate central tendency forecast was seen, to 5.2-5.3 per cent from 4.8-4.9 per cent.
However, the inflation forecasts for both the headline and core rates were revised higher, the core rate to 2-2.2 per cent from 1.7-1.9 per cent. Therefore, the growth-inflation mix has deteriorated. And the slight upward drift in core inflation is expected to persist into 2009, with the forecast for that year also being revised a touch higher. The fact that the January core CPI rose by 0.3 per cent, bringing the year-over-year rate to 2.5 per cent, only adds to the anxiety.
We detect some light inconsistencies in the forecast. First, core inflation is set to be slightly higher still in 2009, despite unemployment in 2009 now expected to be higher too (and GDP growth a touch slower). These developments should be disinflationary but the FOMC does not see it that way, perhaps due to the recent run up in energy and food prices (the weak dollar and rising import prices were already a "known known"), although much of these forecast revisions could simply be a result of persistence from recent data surprises.
Second, real GDP is projected to rise at a touch below the implied trend in 2009 before picking to ever so slightly above it in 2010. This is apparently enough to drive the unemployment rate lower again to 4.9-5.1 per cent by the end of 2008. We believe that stronger growth in the 3 per cent-plus area will probably be required to achieve that outcome.
Finally, the pitfalls of making very long-run forecasts based on unexpected changes in the recent data are visible in this set of FOMC forecasts. Three months ago, the FOMC's unemployment forecast for the fourth quarter of 2010 was 4.7-4.9 per cent. This is meant to be an informal "long-run" estimate of where the FOMC sees the non-accelerating inflation rate of unemployment (NAIRU) and this estimate should not move very often. Yet it only took one bad payroll report (the December report) to shift this implicit NAIRU estimate to 4.9- 5.1 per cent, a rise of 0.2 percentage points.
The forecast range was even more sharp, up to 4.7-5.4 per cent from 4.6-5 per cent.
Overall, the FOMC still sees the risks to growth on the downside and although it suggests it will react to bad inflation news by being less aggressive, financial markets appear to have decided that the Fed is merely doing its duty by talking tough about price stability but will continue to ease aggressively anyway to cushion the blow of the credit crunch.
• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.