The Fed last fall began making public its forecasts for the economy on a quarterly basis. Prior to that, we only got a peek at the Fed’s view of the economy on a semiannual basis for the Fed chair’s semiannual testimony before Congress. The latest Fed forecasts incidentally coincided with the July testimony before Congress and were prepared for the June 24-25 FOMC meeting. Since the subprime crisis broke out at mid-2007, the Fed has been revising its forecasts for growth, unemployment, and inflation – notably for 2008. The revisions have not been good.

What have been key trends for growth?

While the subprime crisis has had an impact on the Fed’s view of the economy, housing has also. The Fed initially did not see the impact of the subprime crisis and depressed housing as lasting much beyond 2007. At the October 2007 FOMC meeting, many Fed officials saw the subprime crisis as moderate and expected housing to pick up during 2008. This resulted in the Fed forecast for real GDP in 2008 to be moderately healthy at 2.2 percent on a fourth-quarter-over-fourth-quarter basis. In October and in subsequent forecasts, the Fed has consistently expected moderate growth in 2009 and near trend growth in 2010.  The two-year out forecast essentially can be seen as the Fed believing it has accomplished its near term goals and that the economy is more or less in optimal equilibrium.

But the near-term forecast has been quite volatile. The Fed was most pessimistic at the April 2008 FOMC – just after the arranged takeover of Bear Stearns by JP Morgan Chase. This was when the financial markets were seen as still quite fragile and the Fed saw the need to open the discount window to investment banks. By the June 24-25 meeting, financial markets had stabilized somewhat and FOMC officials were a little more optimistic about the rest of the year and raised the real GDP forecast to 1.3 percent for 2008.  This is still quite soft but is above recession territory.

The Fed forecasts shown in the charts reflect an average of the Fed forecast ranges. The official Fed forecast tables give an upper and lower range for the forecasts. It is a “central tendency” forecast in that the Fed discards the lowest and highest forecast for each indicator made. The Fed's forecasts are a summary of forecasts prepared individually by each governor on the Federal Reserve Board and each regional Fed president.

Slower growth means higher unemployment

As the Fed lowered its growth forecasts, the Fed raised its forecasts for unemployment. Back in October of last year, the forecasts were still relatively optimistic for 2008 with the final quarter coming in at 4.9 percent. This again reflected the view that the credit crisis would not be long-lasting, that monetary easing would nudge growth back up, and that housing would have recovered during 2008. 

Given the saga of continuing new episodes of the credit crisis and actual worsening in housing, the ramping up of the unemployment rate forecasts for 2008 and 2009 is not surprising. Given that the current unemployment rate is 5.5 percent, the Fed certainly is counting on modest improvement in economic growth to keep the unemployment rate from rising even more than the projected 5.6 percent.

Also, the Fed sees only modest improvement in 2010 as the unemployment rate is seen as still relatively high at 5.3 percent. The unemployment rate forecast clearly implies the Fed sees a sluggish economy over the next 2-1/2 years.

Inflation seen as a worsening problem

The Fed’s inflation forecast can be seen as consisting of three parts. First, the Fed in the near term is interpreting how current trends are playing out in the markets. The second year is essentially a transition period as monetary policy starts to bring inflation from where it is now to where the Fed prefers. The final period (2010) is the Fed’s implied inflation target and indicates where the Fed wants to end up.

Higher oil and other commodity prices along with higher import prices have led the Fed to dramatically double its headline inflation forecast for 2008 from 2 percent as expected last October to 4 percent being projected at the June FOMC meeting. The Fed is counting on a slowing economy and a stabilization in oil prices to start bringing inflation down. Surprisingly, the Fed has not raised its 2009 forecast very much. This can be due to expectations that oil might even decline in price as the economy slows. The Fed anticipates being in its implied target zone of 1-1/2 to 2 percent by 2010.

The Fed’s forecast for core inflation (excluding food and energy) has risen only moderately. For 2008, the forecast was upgraded from 1.8 percent in October to 2.3 percent as soon as the April 2008 FOMC.  Nonetheless, for a relatively stable inflation series, the half a percentage point boost in the forecast is significant. As with headline inflation, the Fed plans on having core inflation within its comfort zone by 2010.

Implied quarterly growth rates

The Fed only publishes fourth-quarter-over-fourth quarter growth rates for growth and inflation and the fourth-quarter level for the unemployment rate. But based on actual data and Fed comments on trends it is possible to put together reasonable scenarios for quarterly growth rates on economic growth and inflation. The charts below represent quarterly patterns that result in the fourth-quarter rates published by the Fed. One should remember that these are not quarterly patterns from the Fed and that a range of quarterly scenarios could fit the same fourth-quarter forecasts.

The first-quarter data do not include the final revisions to GDP since those numbers were not available to the Fed before the June 24-25 meeting.

What pattern does the Fed see for 2008? For real GDP, the second quarter is seen as still sluggish. If one assumes a 1 percent growth rate for the second quarter and gradual improvement during the final two quarters, we still end up with the economy growing at only about a 2 percent pace at year end for the Fed’s fourth-quarter-to-fourth-quarter forecast of 1.3 percent to come true. Essentially, while the Fed has stated that it expects a rebound in growth in the second half, that rebound is projected to be quite modest.

For 2009, the Fed has indicated that growth is expected to be below trend. To end up with a yearly growth rate of 2.4 percent, at least half of the year must be below that rate – possibly a modest 2.2 percent rate. It is unlikely that growth at the end of the year is going to be much higher in order to end up at 2.4 percent for the year.

For quarterly inflation patterns, the Fed sees high energy and food inflation continuing to be high in the near term but improving next year.

For the second quarter of 2008, Fed members did not have the benefit of knowing June inflation data. While the latest PCE price index and CPI numbers imply growth rates for the second quarter of 4.5 percent for headline PCE inflation and 2.0 percent for core PCE inflation, the Fed may have actually forecast on the high side given the hawkish talk of many Fed officials and their fears of a pickup in inflation. If one assumes slightly higher second-quarter numbers of 5 percent for headline PCE inflation and 2.3 percent for core, then we still end up with at least one strong quarter in the second half in order to end up with the Fed’s projections of 4.0 percent and 2.3 percent fourth-quarter-to-fourth quarter, respectively, for headline and core PCE inflation.

What may be surprising is that the Fed is counting on low inflation as soon as late 2009 with inflation rates as low as 2 percent which would be needed to reach the Fed’s goals of 2.2 percent and 2.1 percent headline and core inflation for 2009.

The bottom line

Since October of last year, the Fed has been steadily lowering its growth forecast for 2008 and raising its inflation forecast. A number of Fed officials have grown increasingly hawkish about the need to start fighting inflation. If the Fed really wants to make their 2009 and 2010 forecasts happen and bring down inflation, it will need to act soon. If fact on Tuesday of this week, Philadelphia Fed President Charles Plosser essentially threw down the gauntlet to more reluctant FOMC members saying, “To keep inflation expectations anchored means that monetary policymakers will have to back up their words with action.” For the Fed to have economic reality match its inflation forecasts, it will likely start raising interest rates, barring unexpected calamity in the financial markets.