Fed sees economy slowing

Federal Reserve Chairman Ben Bernanke.

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NEW YORK (CNNMoney.com) -- The Federal Reserve cut its economic growth forecast for the economy Wednesday and suggested that more rate cuts could be on the way to combat further weakness.

The central bank said it now sees the economy growing at a rate between 1.3% to 2% this year, down from its previous forecast from October of growth between 1.8% and 2.5% for 2008.

The Fed also said it expects the unemployment rate for the year to be between 5.2% and 5.3%, up from the 4.8 % to 4.9% range previously given. Unemployment stood at 4.9% in January, according to the latest reading from the Labor Department.

"I thought it was a much more downbeat forecast of the economy than I've seen from them before, but they're still more optimistic than I am," said David Wyss, chief economist for Standard & Poor's, one of a growing number of economists who argue the U.S. economy has already fallen into recession.

But Wall Street appeared to be relieved that the Fed is still looking to cut interest rates. Stocks rallied Wednesday afternoon despite the fact that the Fed also boosted its inflation expectations for 2008. In addition, oil prices hit a new record-high of nearly $101 a barrel.

Defending the big rate cuts

The Fed's gloomier forecast, which was hinted at by Federal Reserve Chairman Ben Bernanke in testimony to the Senate Banking Committee last week, was released along with the minutes from the Fed's two meetings it held in January.

In an attempt to ward off a recession, the Fed slashed rates by three-quarters of a percentage point on January 22 following an emergency meeting the day before and followed that with a half-point cut on January 30.

According to those minutes, Fed members were concerned the emergency rate cut would be perceived as being driven by stock market turmoil rather than economic woes. Some central bank members even suggested there may be a need to raise rates quickly if inflation became a bigger problem.

But in the end, most Fed members agreed that a relatively grim outlook for the economy justified the two big back-to-back cuts in January.

'Downturn' code word for 'recession?'

While the minutes and forecast never mentioned the word "recession," the Fed did discuss the significant risk of an economic "downturn" twice.

Gus Faucher, director of macroeconomics at Moody's Economy.com, said he believes this is as close as the Fed can come to acknowledging the likelihood of a recession.

"I think they're saying we might be in one or we could be in one shortly," said Faucher, who believes the U.S. economy fell into a recession in December.

The minutes from the two-day meeting that concluded on Jan. 30 showed Fed policymakers discussing what further steps they might need to take due to growing risks to the U.S. economy.

"With no signs of stabilization in the housing sector and with financial conditions not yet stabilized, the committee agreed that downside risks to growth would remain even after this action," the Fed said.

Wyss said that's about as clear a signal as the Fed can make that more rate cuts are on the way.

Traders in federal funds futures were already pricing in a 100% chance of another quarter-percentage point cut at the Fed's March 18 meeting even before the release of the minutes.

In its new economic forecast, the Fed said the continued problems in housing and credit markets posed a bigger risk to the economy than previously thought.

"The possibility that house prices could decline more steeply than anticipated, further reducing households' wealth and access to credit, was perceived as a significant risk to the central outlook for economic growth and employment," said the forecast.

Faucher said the Fed's concern that the economy might weaken further is the most striking part of Wednesday's minutes and forecast.

"The emphasis was all on the downside risk," he said.

Still keeping an eye on inflation

The Fed also discussed concerns that commodity prices have stayed higher than expected in the face of the slowing economy. But for the most part, the central bank seemed to dismiss inflation risks.

The minutes said the Fed policymakers agreed the rate cuts "would likely not contribute to an increase in inflation pressures given the actual and expected weakness in economic growth and the consequent reduction in pressures on resources."

However, other members pointed out that once growth prospects improved, the Fed may need to institute a "rapid" increase in interest rates to counter inflation.

According to the minutes from the emergency meeting, at least one member argued the Fed should wait until its regularly scheduled meeting later that month to announce a rate cut.

"Some concern was expressed that an immediate policy action could be misinterpreted as directed at recent declines in stock prices, rather than the broader economic outlook," read the minutes.

This meeting took place while U.S. markets were closed for the Martin Luther King, Jr. holiday. But overseas markets were experiencing a steep sell-off that day, fueling fears that stocks would plunge on Wall Street when the U.S. markets resumed trading on January 22.