Fed Sees Credit, Housing Cutting Into Growth

The Federal Reserve said Wednesday it had lowered its U.S. economic growth forecast for 2008 to between 1.3 and 2 percent due to the deepening housing slump and tight credit and said risks of further setbacks were troubling.

The Federal Reserve headquarters in Washington, DC.

"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," the Fed said in its quarterly forecast.

The U.S. central bank's preceding forecast, released in November, was for growth of between 1.8 and 2.5 percent.

Analysts saw the Fed bracing for the possibility of further deterioration in the economy and prepared to cut benchmark U.S. interest rates even further if necessary. Treasury bonds pared some losses after the Fed statements were released.

"Basically, I think they are clearing the way for more easing (of monetary policy)," said Carl Lantz, an interest rate strategist for Credit Suisse in New York.

SHAKY FOOTING
The forecast and minutes of recent Fed meetings show the central bank worried about a vicious cycle of declining home values, tighter credit and a weakening economy. Concern about recent signs of undesirably high inflation appear relegated to the back burner for most members of the Fed's interest-rate setting Federal Open Market Committee.

"On balance, a larger number of participants than in October viewed the risks to their inflation forecasts as broadly balanced," the Fed said in its forecast, adding that several saw risks that inflation could spike higher.

It signaled that even with its burst of one-and-a-quarter percentage points of rate cuts in two steps to 3 percent in January, the U.S. economy remains on shaky footing. "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," minutes of the Fed's Jan. 29-30 meeting read.

The Fed cut overnight rates by a half percentage point at the scheduled January meeting, after a surprise three-quarter-point reduction less than two weeks earlier.

Benchmark rates have dropped from 5.25 percent in September when the central bank's campaign to cut its fed funds target rate began in an effort to counter the deepening housing slump and a drying-up of credit.

"It's clear they are focused very much on the downside risks and that they might be willing to tolerate a slightly higher core inflation rate in efforts to avoid a U.S. recession," said Matthew Strauss, a currency strategist at RBC Capital Markets in Toronto.

Fed officials saw growth picking up to between a 2.1 and 2.7 percent annual rate in 2009, rising to a 2.5 to 3 percent rate in 2010.

Higher Inflation Seen
Some policy-makers noted the possibility that a rapid economic rebound might ignite inflation, and said they would be ready to counter any such danger by raising rates if need be. "When prospects for growth had improved, a reversal of a portion of the recent easing actions, possibly even a rapid reversal, might be appropriate," the minutes said.

Meanwhile, the Fed raised its 2008 inflation forecast from its earlier projection to between 2.1 percent and 2.4 percent from 1.8 to 2.1 percent. Policy-makers similarly hiked their forecast for core inflation, which strips out energy and food prices, to between 2 and 2.2 percent from 1.7 to 1.9 percent.

Most participants in the policy committee expected inflation to ease from recent highs as energy prices level out and the slowing economy contains costs and price increases. Fed officials also noted that with economies around the world slowing somewhat, some of the external pressures causing price rises may abate too.

In the meantime, most policy-makers saw risks that growth could be slower than they were expecting and that unemployment could be higher.

Despite some improvement in money markets, financial conditions remain strained, as evidenced by stock market gyrations and tighter credit for households and businesses. "The potential for adverse interactions, in which weaker economic activity could lead to a worsening of financial
conditions and a reduced availability of credit, which in turn could further damp economic growth, was viewed as an especially worrisome possibility," the Fed said.

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