Fed Flunked 2007 Recession Forecast

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By Caroline Baum

It was December 2007, the month the U.S. economy fell into a recession that was to last 18 months. The residential real estate market, two years past its prime, was starting to fray. The yield curve, the leadingest of the leading indicators, had been inverted for 1.5 years, warning of recession. Yet at the Federal Reserve, recession wasn't even in the forecast, according to transcripts of the 2007 meetings released today.

Hindsight is 20/20, the saying goes, but when those who missed the early warning signs are still calling the shots, the forecasts merit another look.

At the Dec. 11 meeting, Federal Reserve Board Chief Economist David Stockton presented the staff outlook. Two passages capture the essence:

The fallout from the slump in the housing sector, the ongoing turbulence in financial markets, and elevated energy prices result in subpar growth over the next several quarters. With some further easing of monetary policy, a leveling-off of oil prices, and a gradual improvement of financial conditions, growth picks back up toward potential in 2009.

Overall, our forecast could admittedly be read as still painting a pretty benign picture: Despite all the financial turmoil, the economy avoids recession.

Fed Governor Kevin Warsh, probably the most market-savvy member of the committee, took comfort in the upbeat reading from surveys of business leaders. "Most of these CEOs, who are not great at calling inflection points, still think that their business is okay," Warsh said.

However, members agreed that economic risks were increasing, given rising home defaults and foreclosures and turmoil in financial markets.

Both business leaders and policy makers were wrong. Very wrong. It turns out the Fed's econometric forecasting models failed to account for the way in which toxic subprime loans were transmitted through the financial system. Supposedly an upgrade is underway.

Let's hope the update is complete before it's time for the Fed to unwind its huge balance sheet and restore overnight rates to a more normal level. Policy makers will need all the help they can get.

(Caroline Baum is a Bloomberg View columnist. Follow her on Twitter.)

-0- Jan/18/2013 19:24 GMT