Fed downgrades economic forecast for this year

Published 11:51 pm Wednesday, February 18, 2009

The Federal Reserve on Wednesday sharply downgraded its projections for the country’s economic performance this year, predicting the economy will actually shrink and unemployment will rise higher.

Under the new projections, the unemployment rate will rise to between 8.5 and 8.8 percent this year. The old forecasts, issued in mid-November, predicted the jobless rate would rise to between 7.1 and 7.6 percent.

Many private economists believe the jobless rate — currently at 7.6 percent, the highest in more than 16 years — will hit at least 9 percent by early next year even with the $787 billion stimulus package signed into law Tuesday by President Barack Obama.

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The Fed also believes the economy will contract this year between 0.5 and 1.3 percent. The old forecast said the economy could shrink by 0.2 percent or expand by 1.1 percent.

The last time the economy registered a contraction for a full year was in 1991, by 0.2 percent. If the Fed’s new predictions prove correct, it would mark the weakest showing since a 1.9 percent drop in 1982, when the country had suffered through a severe recession.

The bleaker outlook represents the growing toll of the worst housing, credit and financial crises since the 1930s. All of those negative forces have plunged the nation into a recession, now in its second year.

“Given the strength of the forces currently weighing on the economy,” Fed officials “generally expected that the recovery would be unusually gradual and prolonged,” according to documents on the Fed’s updated economic outlook.

Against that backdrop, unemployment will keep climbing and stay elevated for quite some time, the Fed predicted.

Fed officials anticipated that unemployment would remain “substantially” higher than normal at the end of 2011 “even absent further economic shocks.”

The Fed forecast calls for the jobless rate to dip to between 8 and 8.3 percent next year, and to between 7.5 and 6.7 percent in 2011. All those projections are worse than the Fed’s previous estimates and would put unemployment higher than the normal range around 5 percent.

Employment is usually the last piece of the economy to heal once the country is out of recession and in recovery mode. Businesses are usually reluctant to ramp up hiring until they feel confident that any recovery has staying power.

Under the Fed’s new projections, the economy should grow between 2.5 and 3.3 percent next year. Fed officials “generally expected that strains in financial markets would ebb only slowly and hence that the pace of recovery in 2010 would be damped,” according to the Fed documents.

Fed officials, however, predicted the economy would pick up speed in 2011, growing by as much as 5 percent, which would be considered robust.

Still, given all the economy’s problems, there are risks that the Fed’s forecasts could turn out to be too optimistic.

A few Fed officials — none are identified — feared that it could take five or six years for the economy and employment to get back into a sustainable mode of health.

On the inflation front, the weak economy should mean that companies will keep a lid on price increases this year as they try to lure skittish consumers.

The Fed expects prices to rise between 0.3 and 1 percent this year, down from a projection of between 1.3 and 2 percent in the fall. Prices will pick up slightly in 2010 and 2011 as the economy strengthens.

For now, Fed officials are more worried about falling prices, than rising ones.

The Fed didn’t use the word “deflation,” which is a dangerous bout of falling prices, but officials noted “some risk of a protracted period of excessively low inflation.”

Falling prices sound like a gift at first, at least to consumers, but a widespread and prolonged decline can wreak more havoc on the economy, dragging down Americans’ wages, and clobbering already-stricken home and stock prices. Dropping prices already are hurting businesses’ profits, forcing them to slice capital investments and lay off workers.

America’s last serious case of deflation was during the Great Depression in the 1930s. Japan was gripped with a period of deflation during the 1990s, and it took a decade for that country to overcome those problems.

To revive the economy, the Fed has slashed interest rates to record lows and is expected to leave them there for the rest of this year. It also has rolled out a series of bold programs to bust through credit clogs and is exploring other unconventional tools to provide relief.

Specifically, the Fed at its January meeting said it was “prepared” to buy longer-term Treasury securities if the circumstances warrant such action. Doing so would help drive down mortgage rates and provide help to the stricken housing market, economists said.

Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, preferred moving forward to buy the securities to provide relief, rather than through targeted credit programs, including one to be operational sometime in February to bolster consumer loans. “He saw no evidence of market failures” that made such programs necessary, according to Fed documents of its January 27-28 closed-door meeting.

Several unidentified Fed officials expressed a willingness to expand the size and duration of another program where the Fed is buying debt and mortgage-backed securities guaranteed by mortgage giants Fannie Mae and Freddie Mac. Mortgage rates have fallen since that program was announced late last year.

Even so, Fed officials saw “no indication that the housing sector was beginning to stabilize,” the documents stated.