FOMC: Downside Risks to Growth Remain

The Federal Reserve moved aggressively on the policy front in several directions. First, the volume of TAF (temporary auction facilities) was increased from $40 billion in December to $60 billion in January. Second, the FOMC voted to reduce the target federal funds rate by 75 basis points at a special inter-meeting conference call on January 21. Third, the Fed voted to reduce the federal funds rate by a further 50 basis points at its regularly scheduled meeting on January 30.

While the Fed conceded that the fiscal stimulus package would boost growth in the second half of 2008, it would not mitigate the risks in the very near term. In addition, the fiscal stimulus measures lapse in early 2009, so they would only have a temporary impact. With no signs of stabilization in the housing sector, and financial conditions not yet stabilized, the FOMC conceded that downside risks to growth remained even after reducing the federal funds target to 3.00% on January 30.

Not only did the FOMC slash its central tendency forecast for 2008 growth by 0.5 percentage point, to a range of 1.3% to 2.0%, the range of the FOMC's projections widened out to a stunning 1.2 percentage points, up from 0.6 percentage point in the October forecast. With respect to the inflation outlook, the FOMC conceded in its central tendency forecast that it was unlikely that core inflation could be kept below 2.0% in 2008, in view of the pipeline pressures from recent increases in crude oil prices. However, it does forecast that core inflation will drop below 2.0% in 2009 and 2010.

The immediate and urgent issue that the Fed has to deal with in the next three months is that the growth outlook has deteriorated even since the updated central tendency forecasts were assembled at the end of January. Despite the substantial projected boost from the fiscal stimulus in the second half of 2008, we expect overall real GDP growth to chin the bar at just 1.3% this year, which is at the lower end of the Fed's central tendency forecast. Problems in the financial and credit markets have deteriorated further, with a substantial tightening in credit conditions now surfacing even in the normally very sleepy municipal bond markets, mainly as a consequence of downward pressure on the ratings of the bond insurers. Consumer confidence has plummeted, signaling further weakness in consumer spending in February and March. While the recent uptick in core CPI inflation in January to 0.3% is disturbing, a good deal of the increased pressure on core prices is connected with anomalous spikes in cigarette and personal computer prices. Moreover, this one-month uptick follows a long string of re-calculated moderate increases of 0.2% in 2007.

The bottom line is that even with the federal funds rate sitting at 3.00%, the FOMC is of the view that near-term downside risks to growth remain. Global Insight agrees, and recent indicators on the economy have validated this outlook. As a result, we expect the FOMC will move to lower interest rates by an additional 50 basis points at its next meeting on March 18, and then move to reduce rates again by 50 basis points on April 30.