The minutes from the Oct. 30-31 meeting of the Federal Open Market Committee, the Federal Reserve's policy-setting arm, were more cautious on the outlook for U.S. growth than we expected, and compared to the FOMC's Oct. 31 policy statement, which stated that reported risks between growth and inflation were balanced. Indeed, the minutes, and accompanying policy projections, both released Nov. 20, suggest risks are tilted to the downside on growth.
The minutes displayed a more downbeat slant on the Fed's growth outlook, given risks of a self-reinforcing spiral on credit tightening and growth. Though the Fed indicated its decision to cut rates on Halloween was a "close call," bond market bulls have pounced on its projections of slower growth even with the recent rate cuts, though the Fed also highlighted the usual concerns about inflation risks. This suggests that the Fed's "balanced" risk assessment may be tipping toward slower growth and, therefore, a more relaxed policy stance.
Revised Growth Estimates
The FOMC projections that accompanied the minutes contained two surprises. First, the Fed has low-balled growth, with a 2.3% to 2.7% central tendency forecast for 2008 that would have come in slightly below market median forecasts at the time of the October meeting. Projected growth bounces back somewhat to the 2.5%-2.6% range by 2010. If this is a "trend growth" estimate it would reflect a disappointing productivity outlook, as also suggested by the accompanying sideways trend in the unemployment rate through 2010 with a 4.7% to 4.9% central tendency.
The revisions also reflect comments within the minutes that suggest that Fed policymakers have revised downward their estimates of sustainable growth based on the midyear downward revisions to gross domestic product growth over the last three years. The GDP estimates in the Fed's forecast table might also realistically incorporate some likelihood of a recession at some point during these late years of an expansion, but this possible hedge against downside risk to GDP is not associated with any upside surprise in the unemployment rate forecasts, which essentially peg a sideways movement in the rate at a level just above the most recent 4.7% rate.
Raising Inflation's Comfort Zone
Second, the Fed has high-balled inflation relative to what might be expected given that these figures can be interpreted as the first statement of the Fed's real inflation objective. Fed rhetoric often suggests a 1% to 2% "comfort zone" for inflation as measured by the personal consumption expenditure chain price index, so one might have expected some obligation for policymakers to generate forecasts consistent with that range. Yet, the central tendency shows both headline and core inflation hovering entirely in the upper half of that band, though the Fed does forecast a moderation in headline inflation from the 3% area to the 1.6% to 1.9% range by 2010. It would appear that the "comfort zone" is really 1.5% to 2%.
The Fed's relatively low growth estimates for 2007 and 2008 suggest that "surprises" in economic data since Oct. 31 could still be absorbed into the existing figures without an easier policy stance, even if growth prospects in the market are being downgraded. For GDP, the numbers for 2007 are already below market forecasts given data since October. The third-quarter GDP gain looks poised for nearly a 1% upward revision in the next report, so the Fed's 2.4% to 2.5% central tendency for 2007 would require a fourth-quarter GDP gain of just 0.5% to 0.9%, which lies below most market forecasts. The Fed's 2.3% to 2.7% range in 2008 leaves room for a weak first quarter as well.
For inflation, soaring oil prices imply that we will outpace the Fed's PCE assumption for 2007 of a 2.9% to 3.0% gain, as this would require a fourth-quarter PCE chain price gain of only 2.1% to 2.5% vs. our 3.1% forecast. Core inflation is on track, however, for the 1.7% to 1.9% range. It is noteworthy that the Fed held these views on growth and inflation at the time that they adopted a neutral balance of risk statement.
The combination of what the Fed said in the minutes—and its estimates for future growth—leave the door open for further rate cuts ahead. And the market is making its own forecasts in that regard. Trading in Fed funds futures—a vehicle for market pros to make bets on future interest rate moves—on Nov. 20 showed that investors overwhelmingly expect a quarter-point easing when Bernanke & Co. next meet in December.