Federal Reserve makes modest downward adjustment to its growth expectations

The FOMC modestly lowered its projection for growth in 2010-1012 and similarly lowered its forecasts for inflation over the same period. The change to the growth outlook for 2010 (the central tendency was lowered to 3.0%-3.5% from 3.2%-3.7%) was made to reflect incoming data on the second quarter and tighter financial conditions resulting from spillover effects from Europe (stronger dollar, lower equity prices, wider spreads). Nonetheless, the central tendency range, if realized, would likely not imply a slowing in growth in the second half of the year relative to the first half. For 2011 and 2012 the Fed still sees a significant pickup in growth to 3.5%-4.2% in 2011 and 3.5%-4.5% in 2012. However, the minutes emphasized the uncertainty surrounding the outlook and it seems that more FOMC members are concerned about the downside risk to growth.

The Fed lowered the inflation outlook for core PCE prices for 2010 to 0.8%-1.0% from 0.9%-1.2% in April. The core inflation outlook was also lowered modestly in both 2011 and 2012 (see table for details). In part the forecast changes appeared to reflect a reappraisal of the outlook for unemployment (higher) while maintaining a full employment assumption of 5.0%-5.3%. The commentary accompanying the forecast emphasized disinflation risks with some members expressing concerns about potential deflation risks.

Despite the forecast changes, which were described as modest, the minutes said that no further policy action was viewed as necessary at this stage. However, the minutes suggested that the Fed believes it may need to evaluate its policy options if growth turns out to be significantly weaker in the second half of the year.

Key quotes


Forecast Outlook

“participants generally made modest downward revisions to their projections for real GDP growth for the years 2010 to 2012, as well as modest upward revisions to their projections for the unemployment rate for the same period. Participants also revised down a little their projections for inflation over the forecast period.”

“these revisions were largely the result of the incoming economic data and the anticipated effects of developments abroad on U.S. financial markets and the economy.”

“Participants generally anticipated that, in light of the severity of the economic downturn, it would take some time for the economy to converge fully to its longer run path as characterized by sustainable rates of output growth, unemployment, and inflation consistent with participants’ interpretation of the Federal Reserve’s dual objectives; most expected the convergence process to take no more than five to six years.”

“Most participants judged that their projections of future economic activity and unemployment continued to be subject to greater-than-average uncertainty.”

“About one-half of the participants saw the risks to their growth outlook as tilted to the downside; in contrast, in April a large majority of participants saw the risks to growth as balanced. In the current survey, a substantial number of participants also viewed the risks to unemployment as tilted to the upside. The remaining participants saw the risks to the projections for economic growth and unemployment as roughly balanced.”

“Nonetheless, the possibility that inflation expectations might start to decline in response to persistently low levels of actual inflation and the potential effects of continued weakness of the economy on price trends were seen by a few participants as posing some downside risks to the inflation outlook.”

“A few participants cited some risk of deflation.”

Policy

“In sum, the changes to the outlook were viewed as relatively modest and as not warranting policy accommodation beyond that already in place. However, members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably.”

BOTTOM LINE

While the adjustments to the forecast seem very modest, the language about risks to the outlook and the need to consider further stimulus if the outlook worsens appreciably suggests a more significant shift in the FOMC’s thinking. We read these minutes as providing significant support for our forecast that the Fed is unlikely to hike rates before September 2011 at the earliest.

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