Note to the Fed: Nothing's 'shocking'
The new economic forecast for 2010 is downright rosy -- but that's partly because it excludes the possibility of 'further shocks.' Is that really realistic?
NEW YORK (CNNMoney.com) -- The Federal Reserve issued new economic forecasts Wednesday afternoon. To nobody's surprise, the central bank's outlook for 2009 is gloomier than before: it expects the economy to shrink by as much as 1.3% and the unemployment rate to climb as high as 8.8%.
By way of comparison, the Fed was predicting back in October that in the worst case scenario, the economy would only shrink 0.2% this year. And its forecast for unemployment ranged between 7.1% and 7.6% The unemployment rate is already 7.6%.
So the Fed, like many (me included), underestimated the severity of this recession.
But is the Fed still too optimistic? Many believe that to be the case.
Michael Strauss, chief economist with Commonfund, a money management firm based in Wilton, Conn., said he thinks the nation's gross domestic product will fall at least 5% in the first quarter.
And even if the economy starts to bounce back a bit later in the year -- after the effects of this year's stimulus bill and all the Fed's moves of the past year take hold -- Strauss still thinks the economy is likely to shrink by about 2% for the year.
The big reason for this is that Strauss believes the Fed may be underestimating consumers' newfound sense of thrift.
"What the Fed might be hoping for is that once the economy gets going, it may have some spontaneous combustion," he said. "But consumers will need to spend several quarters, if not years, to rebuild savings."
If he's right, that is encouraging news for the long-term health of the economy. Consumers need to spend more wisely and rely less on debt so we can avoid having another credit bubble anytime soon. But in the short term, increased savings keeps a lid on economic growth.
With this in mind, you also can't help but call into question the Fed's new forecast for 2010.
Even though some (me included again) think the chances of the economy bottoming out later this year are good, and that there could be a modest recovery next year, the Fed's 2010 outlook is downright ebullient.
The central bank thinks the economy will grow between 2.5% and 3.3% next year. So is there something that the Fed sees that other economists, the financial markets and consumers don't? Or are they passing around the same pipe that got Michael Phelps into trouble?
I've tried to remain level-headed about the markets and economy when writing this column, and I've taken flack from many readers for my optimism.
But I've never denied that the economy is in very poor shape; I've merely maintained that this is not a depression and that there is a path to an eventual recovery. I still feel that way.
That said, even I have trouble trying to figure out how the economy can bounce back as sharply as the Fed thinks it will next year. And I'm certainly not alone.
"The Fed is always slow to forecast downturns and quick to forecast recoveries; that is the nature of central banks just about everywhere," wrote Ian Shepherdson, chief U.S. economist for research firm High Frequency Economics, in a report Thursday.
Shepherdson added that he hoped the Fed is right "for the sake of everyone," but that he just did not see how the finances of consumers could improve in the timeframe implied by the Fed's forecasts.
It appears that the biggest reason for the Fed's decidedly rose-colored view is that the forecasts reflect how the economy could do "absent further shocks."
This is understandable. Of course, the Fed can't really come out and scare the bejesus out of everyone with the economic equivalent of prophecies of plagues of locusts.
Still it may not be realistic, given the depth of this recession, to make assumptions about the economy "absent further shocks."
Would the nationalization of a major bank such as Citigroup (C, Fortune 500) or Bank of America (BAC, Fortune 500) be a "further shock?" Yes. But that's now a scenario that many believe is plausible.
How about the bankruptcy of General Motors (GM, Fortune 500)? That would be a "further shock." And that also is something that unfortunately is not out of the realm of possibility.
Or how about another big round of corporate layoffs like we had in January? That could send the unemployment rate even higher and deepen the erosion of consumers' spending power. This would also be a "further shock" which, upon further inspection, isn't really shocking.
But since the Fed is not attempting to factor in such shocks, their new forecasts have to be taken with copious grains of salt.
Kurt Karl, chief U.S. economist with Swiss Re, rates the likelihood of the economy growing at the rate the Fed is forecasting for next year at just 15%.
And that's despite the fact that Karl said he is optimistic that the worst could be over in the housing market by the end of the year and that stimulus will help as well.
But Karl added that the key to a sustainable recovery is restoring the health of the banking sector. So far, the efforts from the Treasury Department and Fed have borne little fruit. Until they do, corporations are likely to remain in cash preservation mode, which could lead to even more layoffs.
And as long as companies keep shedding jobs, it is going to be more difficult for the overall economy to rebound sharply -- even if some segments of the economy improve.
"To meet the 2010 numbers you have to start stabilizing in the next few months. But we have had such a long period of tightened credit conditions, which is inhibiting business investments. So it's a stretch," Karl said. 
