Fed slashes GDP growth forecasts

The Federal Reserve has slashed its forecasts for American economic growth this year. An expected combination of below trend GDP growth and above trend inflation has led to many commentators discussing the possibility of stagflation.

In its summary of economic projections, published last week along with its latest minutes, the Fed forecast real GDP growth to be at a central tendency of 1.3-2.0% this year.* This compares with a projection of 1.8-2.5% in October. Back in July 2007, in its regular report to congress, it forecast growth of 2.5-2.75% for 2008.

The Fed said the economy would grow substantially below its trend rate: “owing primarily to a deepening of the housing contraction and a tightening in the availability of household and business credit”. Problems in the financial markets and higher oil prices were also playing a role.

Falling economic growth is likely to coincide with rising unemployment and higher inflation. The central tendency for unemployment in 2008 is forecast at 5.2-5.3% compared with a projection of 4.8-4.9% in October. PCE [personal consumption expenditure] inflation is forecast at a central tendency of 2.1-2.4% compared with a projection of 1.8-2.1% in October.

However, several factors could lead to an economic pick-up. Some members of the Federal Open Markets Committee expected the Bush administration’s fiscal stimulus package to begin bolstering domestic demand by late 2008. After that an improving housing market, falling interest rates and a recovery in the financial markets should take effect. By 2010 the economy is expected to be growing at or a little above its trend rate.

The Fed’s forecast for American GDP growth in 2008 is broadly in line with the International Monetary Fund (IMF). In January the IMF forecasted growth of 1.5% this year.

*Available at www.federalreserve.gov