Fed sees economy slowing in 2008

Federal Reserve Chairman Ben Bernanke

The Fed's new outlook The central bank gave new forecasts for growth, unemployment and inflation. '07 '08 '09 GDP 2.4-2.5% 1.8-2.5% 2.3-2.7% Unemployment 4.7-4.8% 4.8-4.9% 4.8-4.9% PCE Inflation 2.9-3% 1.8-2.1% 1.7-2% Core PCE Inflation 1.8-1.9% 1.7-1.9% 1.7-1.9% Source:Federal Reserve

NEW YORK (CNNMoney.com) -- The Federal Reserve said that the decision to cut a key interest rate last month was a "close call," according to minutes from that meeting released Tuesday.

But in a new economic outlook, the central bank also lowered its growth target for the economy in 2008, raising hopes that the Fed will cut rates again when it meets in December.

The Fed indicated in an addendum to its minutes that it now expects the economy to grow at about a 1.8 percent to 2.5 percent rate next year, down from a forecast in June of 2.5 percent to 2.75 percent growth.

"I am surprised that their forecast for next year is as low as it is," said David Resler, chief economist of Nomura Securities International Inc. "The forecast is considerably weaker than it had been and that is the most significant development in this report."

And while Resler said he does not think a rate cut at the Fed's next meeting on Dec. 11 is a foregone conclusion, he thinks it is more likely now given what the Fed thinks about the prospects for the economy in 2008.

To that end, according to the most recent price of futures listed on the Chicago Board of Trade, investors are pricing in a 92 percent probability that the Fed will lower its key federal funds future rate by a quarter of a point to 4.25 percent on Dec. 11.

The federal funds rate is an overnight bank lending rate that influences how much interest consumers pay for credit card borrowings, home equity lines of credit and auto loans.

Stocks fell immediately following the release of the minutes and the Fed's new economic outlook but rallied toward the end of the day and wound up finishing in positive territory.

In its forecast, the Fed cited "tightened terms and reduced availability of sub-prime and jumbo mortgages, weaker-than-expected housing data, and rising oil prices" as the main reason for revising its projections downward.

The Fed also issued relatively sluggish growth targets for economic growth in the next two years. The Federal Reserve governors and Federal Reserve Bank presidents indicated that they anticipate the economy to grow at a 2.3 percent to 2.7 percent clip in 2009 and at a 2.5 percent to 2.6 percent rate in 2010.

Since the Fed last cut rates on Oct. 31, several large financial services companies - including Citigroup (Charts, Fortune 500), Merrill Lynch (Charts, Fortune 500), Washington Mutual (Charts, Fortune 500) and Bank of America (Charts, Fortune 500) - have reported writedowns due to the subprime mortgage crisis.

And both Fannie Mae (Charts) and Freddie Mac (Charts, Fortune 500), government-sponsored enterprises that help provide financing to the mortgage market, reported weak third quarter results.

Shares of Freddie Mac plunged more than 30 percent Tuesday after the company announced a quarterly loss and said it may have to cut its dividend due to concerns about its capital.

Jack Ablin, chief investment officer for Harris Private Bank, called the problems at Fannie Mae and Freddie Mac a "big setback for solving the credit crunch" and said that fears about the financial health of these two companies could keep the Fed in easing mode for the foreseeable future in order to make sure that the mortgage crisis doesn't deepen further.

"The Freddie and Fannie situation is ominous," Ablin said.

But one economist noted that the Fed did not think the unemployment rate would rise substantially in the next few years and that this is a good sign, even though the Fed is predicting slower growth.

The Fed indicated that it expects the unemployment rate in 2008 to fall between 4.8 percent and 4.9 percent, up slightly from the Fed's June forecast of 4.75 percent. The central bank also said it expected the unemployment rate to stay roughly in this range in 2009 and 2010.

"I think the Fed is saying we are not going to have a recession. That has to be the conclusion you take from this outlook," said Keith Hembre, chief economist with First American Funds.

Resler said, however, that he saw a disconnect between the Fed's growth outlook and unemployment forecast. He said if the Fed's most pessimistic predictions for the economy are correct, the unemployment rate will probably be much higher than what the Fed is currently forecasting.

"If we hit the lower end of the Fed's growth forecast, I'd be shocked if the unemployment rate wasn't over 5 percent and even close to 5.5 percent," he said.

Jeffrey Saut, chief investment strategist for Raymond James, said he has trouble believing that the unemployment will remain as low as the Fed thinks it will.

"Most people take what the Fed says at face value. But I don't believe it. When the Fed comes out and tells me the unemployment rate is going to stay below 5 percent, that's hogwash," he said.

And Ablin said that it's curious to see the Fed lowering its growth targets without significantly raising its unemployment forecast.

"I don't know if the Fed is trying to talk the economy up or just living in a dream world," Ablin said.

In the Fed's new outlook, the first since announcing last week that it would now provide four economic updates a year as opposed to the two a year it had previously given, the central bank also discussed its prediction for inflation.

The Fed hinted that it did not expect inflation to be a concern, despite the spike in the prices of oil and other commodities and the declining value of the dollar, in the coming years. The Fed said it expects so-called core inflation to be between 1.7 percent and 1.9 percent next year and in 2009.

But one bond fund manager who asked not to be named said that even though the Fed may believe that inflation will moderate, the fact that the Fed thought the decision to cut rates last month was a "close call" indicates that the Fed still is fairly concerned about inflation and is reluctant to lower rates further.

"The Fed is still hesitant to embrace this new world idea that high oil prices are a tax for the consumer. They still seem to be worried that oil prices are inflationary," the bond fund manager said. "If they cut rates again, that could push oil prices higher and add more to the dollar's weakness."

With that in mind, the bond fund manager said that if oil prices head above $100 before its next meeting, the Fed may decide to keep rates unchanged, even if investors want the Fed to cut rates again.

"At best, a rate cut is a confidence booster but rate cuts come at a cost," the bond fund manager said.