Testing the limits of "resilience"

Futures, Jan 2008 by Beckner, Steven K

The year ahead will provide a test of the U.S. economy's "resilience," about which Federal Reserve officials have so often spoken. The Fed's own flexibility, guts and credibility may also be tested.

So far, the Fed has done all that reasonably could have been expected. In the second half of 2007, as the housing slump deepened and the subprime mortgage implosion sent shockwaves through the financial system, the Fed responded with alacrity to contain the economic damage.

Not only did it slash the federal funds and discount rates, it aggressively provided liquidity through open market operations and liberalized the collateral it would accept for loans.

Despite lingering concerns about inflation and inflation expectations prompted by dollar depreciation and soaring oil prices, a risk-managing Fed preemptively "insured" against recession. The jury remains out on just how effective the Fed's ministrations were.

How much more aggressive will the Fed need to be - or should it be - in 2008? Will our "resilient" locomotive again show its stuff and, perhaps with the help of the U.S. Treasury-coordinated freeze on subprime teaser rates, pull the economy out of its quagmire ? Or will housing and housing finance problems continue to fester and spill over, dragging down demand?

The Fed's best guess, as expressed in its policymaking Federal Open Market Committee's (FOMC) first quarterly three-year forecast released Nov. 20, is that the economy will rebound rhis year from what was expected to be pretty paltry fourth quarter growth.

The "central tendency" forecast of Fed governors and Federal Reserve Bank presidents is for real GDP growth of 1.8% to 2.5% on a fourth quarter over fourth quarter basis this year; a sharp downward revision from the July forecast of 2.5% to 2.75%. Unemployment is projected to average 4.8% to 49% in the fourth quarter, up from 4-75%.

Growth is projected to pick up to 2.3% to 2.7% in 2009 and 2.5% to 2.6% in 2010, with unemployment around 5%.

Core inflation, meanwhile, is expected to run between 1.7% and 1.9% this year, a bit lower than the 1.75% to 2% forecast released in July, and stay close to that range in 2009 and 2010.

Those forecasts, compiled at the Oct. 31 FOMC meeting, carry an assumption of "appropriate monetary policy." That means the future policy is most likely to "foster trajectories for output and inflation consistent with the participant's interpretation of the dual mandate of price stability and full employment."

Given some of the more dire private predictions, the FOMC forecasts don't sound too bad. But as the Fed said in an accompanying statement, "most participants viewed the risks to their GDP projections as weighted to the downside and the associated risks to their projections of unemployment as tilted to the upside."

"Participants were concerned about the possibility for adverse feedbacks in which economic weakness could lead to further tightening in credit conditions, which could in turn slow the economy further," it continued.

Moreover, after the forecasts were released, some of those downside risks were indeed realized.

In late November, Chairman Ben Bernanke warned that "higher gas prices, the weak housing market, tighter credit conditions and declines in stock prices were likely to create some headwinds for the consumer."

The FOMC would need to judge whether the balance of risks to the economic outlook had shifted materially and would need to be exceptionally alert and flexible in such uncertain times, he said.

The Fed has, arguably, played its lender of last resort role responsibly and, despite some internal dissent, judiciously lowered the cost of money to insure against economic weakness.

The philosophy was aptly expressed by Vice Chairman Don Kohn: "People should bear the consequences of their decisions about lending, borrowing, and managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill advised... however, when the decisions do go poorly, innocent bystanders should not have to bear the cost."

But the Fed cannot throw caution to the wind. As recently as August, the FOMC was leaning toward raising rates to curb inflation. Numerous officials have continued to warn that inflation risks remain. They are also conscious that it was the Fed's draconian rate cuts early in the decade, however justified they seemed at the time, which set the stage for the housing boom-bust that continues to afflict the economy.

Having put substantial easing in place, the full effects of which will only be felt later, the FOMC is apt to proceed cautiously this year, lest it set the stage for more problems down the road.

Steve Beckner is senior correspondent for Market News International, which sponsors his Web site "The Beckner Report." He is regularly heard on National Public Radio and is the author of Back From the Brink: The Greenspan Years (Wiley).