Fed sees economy getting worse

Ben Bernanke & Co. lower 2008 economic growth forecast and raise their projections for inflation and unemployment; says last rate cut was a "close call."

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By Chris Isidore, CNNMoney.com senior writer

Federal Reserve Chairman Ben Bernanke.
Federal Reserve Chairman Ben Bernanke.
What is to blame for high oil prices?
  • OPEC
  • Big oil companies
  • Supply and demand
  • They are unavoidable

NEW YORK (CNNMoney.com) -- The Federal Reserve sees worse economic problems ahead, according to new forecasts from the central bank released Wednesday.

But even so, the Fed may be reluctant to cut interest rates any further than it already has, the minutes from its last meeting show. (The minutes were also released Wednesday.)

The Fed lowered its economic growth forecast for the year. At the same time, it raised its projections for inflation and unemployment. The combination of slowing growth and rising prices created a difficult situation that made the Fed's latest decision to cut rates on April 30 a "close call."

Stocks, which were trading a bit lower before the release of the minutes, fell even further after the new forecast was revealed. The Dow finished the day with a more than 220 point loss.

The central bank said it now believes full-year economic growth will be between 0.3% and 1.2% this year, significantly below its previous forecast of 1.3% to 2% growth in January.

The Fed said in its minutes that members now expect the economy to shrink in the first half of the year -- the clearest signal yet that Federal Reserve chairman Ben Bernanke and other bankers believe the economy is in a recession.

But some policymakers argued the Fed has cut rates enough already and that the central banks should not lower rates further unless there is evidence of "significant weakening."

The Fed also raised its unemployment forecast for the year to between 5.5% and 5.7%, up from its earlier estimate of 5.2% to 5.5%. The unemployment rate was 5% in April.

In addition, the Fed boosted its projection for inflation. It said it now expects personal consumption expenditures to rise between 3.1% and 3.4% in 2008, a full percentage point more than its earlier expectation.

Even when soaring food and energy prices are stripped out, the Fed expects steeper "core" inflation than its previous estimate.

The Fed cut its federal funds rate, a key short-term rate, by a quarter- percentage point at the end of its last meeting on April 30. According to the minutes, that decision was viewed as a "close call" partly because of rising inflation pressures.

"I think they are stating more clearly that we are in a recession, but the main thing to take away from this is that they're not going to cut any further," said Gus Faucher, director of macroeconomics for Moody's Economy.com.

The Fed' indicated it is expecting a pickup in economic growth in the second half of this year, as the effect of its previous rate cuts and tax rebates to consumers start to impact the economy.

But while it said it expects the economy to recover a bit next year -- forecasts call for growth of 2% to 2.8% in 2009 -- the Fed still sees some weakness lingering into next year.

The central bank now thinks the unemployment rate in 2009 will be between 5.2% and 5.7%, up from an earlier projection of 5% to 5.3%. The Fed said it expects to see "noticeable slack" in the economy next year.

"They're not looking for a deep recession. But they're not expecting a heck of a lot of rebound," said David Wyss, chief economist with Standard & Poor's.

He added that the latest forecast is simply catching up with the consensus view among economists that the nation has already fallen into recession. He warned that the Fed's outlook may deteriorate even further in light of the spike in oil prices in just the past few days.

"Remember, this is their thinking of three weeks ago," Wyss said. "They might have even a different view on inflation and GDP today."

In an effort to keep the country from falling into recession and to deal with the credit crisis, the Fed has cut its key federal funds rate seven times since September. This short-term interest rate is now 2%, down from 5.25% at the start of the Fed's easing campaign,

The federal funds rate is a benchmark for home equity lines of credit, credit cards and other consumer loans as well as the prime rate used for short-term business loans.

Keith Hembre, chief economist at First American Funds, said that it makes sense that the Fed is now paying more attention to inflation pressures.

Some believe the Fed cuts since last September helped fuel inflation, especially the sharp run-up in oil prices, because the rate cuts have led to a weakening of the dollar.

Along those lines, the two Fed members who voted against the last rate cut -- argued during the meeting that the Fed cuts were hurting the economy more than helping it.

Dallas Federal Reserve president Richard Fisher and Philadelphia Federal Reserve president Charles Plosser both contended that the rate cuts have fed inflation and cut into spending by consumers and businesses.

"They believed that another reduction in the funds rate at this meeting could prove costly over the longer run," the Fed said in the minutes.

So Hembre thinks the Fed wants to send the clear signal that it is on hold on interest rates for the foreseeable future.

"They don't want to exacerbate it by the expectation of further rate cuts," he said. To top of page

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