(cache) Fed Forecasts Emphasize Risks

WASHINGTON -- Federal Reserve officials, in a new and expanded forecast, expect the nation's economy to grow sluggishly next year and see risks of an even worse performance.

They also expect food and energy prices to continue putting upward pressure on inflation, but say underlying inflation is now, and will remain, within the target range implied by their new forecast.

• The Forecasts: Fed officials expect sluggish growth next year with a risk of an even worse pace. They also believe food and energy will still pressure prices, but say underlying inflation remains in their target range

• The Implications: The new forecasts suggest officials are open to the need to cut rates again, but a different message emerged from accompanying FOMC minutes that called October's decision to cut rates, rather than leaving them unchanged, a "close call."

The enhanced forecasts by officials of the Fed's policy-setting Federal Open Market Committee underline the conflicting pressures on the central bank to cut interest rates to protect economic growth or to hold them steady to quell inflation.

The details of the forecasts, released yesterday, suggest officials remain open to the need to cut rates again in coming months. A different message comes from the accompanying summary of the FOMC's Oct. 30-31 meeting, which ended with a decision to cut the target for the Fed's key interest rate to 4.5% from 4.75%. The minutes say the decision to cut rates, as opposed to leaving them unchanged, was a "close call."

The Fed ended the October meeting with a statement saying risks of weaker growth and higher inflation were balanced. Officials since have suggested no inclination to cut interest rates again. Nonetheless, markets continue to expect another quarter-point rate cut next month. The forecasts may bolster those hopes, because they reinforce the impression that despite the Fed's officially neutral stance, it is, in fact, worried more about growth than inflation.

REAL TIME ECONOMICS

• Greg Ip parses the new forecasts from the Fed, plus read the latest news and analysis on the economy at WSJ.com's Real Time Economics blog.

• Full text of the minutes

Officials last month saw a "substantial risk" to economic growth but also inflation risks stemming from rising unit labor costs, a "significant" weakening in the dollar, higher energy costs, and some evidence that the bond market was anticipating higher inflation, the minutes of the meeting show. The rate cut was described as "significant valuable insurance against an unexpectedly severe weakening in economic activity." By describing the cut as "insurance," the minutes imply that the outlook, by itself, didn't call for more rate cuts.

Most FOMC members see U.S. gross domestic product growing next year by between 1.8% and 2.5%, down from their June projection of 2.5% to 2.75%. The ranges represent the forecasts of all 17 members minus the three highest and three lowest forecasts.

The FOMC members' forecast is more pessimistic than that of private economists polled by The Wall Street Journal, who see 2.4% growth next year. Just two members expect growth higher than that consensus; 11 see it lower. The officials see growth returning to a range of 2.3% to 2.7% in 2009.

The Fed appears to put the economy's "potential" growth rate -- what it can achieve given long-term growth in the work force and output per worker -- at a mere 2.5%, well below the average annual growth of 3.1% recorded over the past 12 years and the Congressional Budget Office's 2.9% estimate of potential growth. That means a growth rate that others consider substandard might be viewed as healthy, or even inflationary, by the Fed.

FOMC members expect overall inflation, measured by the price index for personal-consumption expenditures, of 1.8% to 2.1% next year, reflecting continued upward pressure from rising energy and food prices. They expect core inflation, which excludes those two factors, of 1.7% to 1.9%. With core inflation now 1.8% and expected to remain there, the Fed isn't under pressure to push it lower.

By 2010, the Fed official said they expect overall and core inflation between 1.6% and 1.9%. Given that Fed officials expect to be able to achieve their desired inflation rate within three years, this range is the Fed's de facto inflation target. The 1.75% midpoint of this range is higher than that of the 1% to 2% comfort zone popularized in 2002 by Ben Bernanke, then a Fed governor and now Fed chairman. Mr. Bernanke is a longstanding advocate of setting a specific, publicly disclosed inflation target. The new forecasts, which are to be released quarterly, are a step in that direction.

In discussing the economic forecast, FOMC members cited such downside risks as the possibility that: "markets could relapse or that current tighter credit conditions could exert unexpectedly large restraint on household and business spending"; "adverse feedbacks in which economic weakness could lead to further tightening in credit conditions"; and "more severe contraction in the housing sector and a substantial decline in house prices." The only upside risk was evidence that previous periods of financial distress had not had much impact on growth. They also say the outlook is more uncertain than usual, and most of the sources of that uncertainty are negative for growth.

Officials cite only a few upside risks to their inflation forecasts. "Recent increases in energy and commodity prices and the pass-through of dollar depreciation into import prices would raise inflation," and elevate public expectations of inflation. FOMC members "were more persuaded than they had been in June that the decline in core inflation readings this year represented a sustained albeit modest step-down," the minutes said.

The minutes, and an accompanying study by staff economists David Reifschneider and Peter Tulip, emphasize that projections are subject to a lot of forecasting error, and those errors grow the further the forecast goes into the future. Based on the track record of forecasts, they say there's a 70% chance growth will be 1.3 percentage points higher or lower than the FOMC forecasts next year, and 1.4 points higher or lower in subsequent years.