Too Much Optimism at the Fed

The Fed says the economy has gotten worse than it ever expected. But the Fed governors and bank presidents forecast that it will not get much worse.

The Fed’s late-January forecasts out today say that the members of the Federal Open Market Committee “viewed the outlook for economic activity and inflation as having weakened significantly since last October, when their last projections were made,” and think that when recovery comes, it will be “unusually gradual and prolonged.”

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

But when I looked at their forecasts, they did not seem very pessimistic. The “central tendency” of Fed forecasts—meaning the range leaves out the three most optimistic and pessimistic of the committee members—is for the economy to shrink by 0.5 percent to 1.3 percent for 2009, in contrast to a decline of 0.2 percent in 2008.

The economy is supposed to begin recovering by midyear, and grow 2.5 to 3.5 percent in 2010 and 3.8 to 5.5 percent in 2011.

The unemployment rate, 7.6 percent in January, is expected to grow to 8.5 to 8.8 percent by the fourth quarter, and then fall back in 2010 and 2010.

If those forecasts turn out to be accurate, President Obama and Treasury Secretary Timothy F. Geithner will have every right to take a victory lap.

But the Fed has been consistently overoptimistic. As the economy deteriorated in 2008, they did not see how bad it was until the data made it clear. In the summer, the Fed officials saw the brief upward blip in economic activity caused by the tax rebates and thought it would continue. They raised their forecasts for 2008 growth.

In the most recent forecast, made at the end of October, the low end of the central tendency forecast for 2008—with only two months left—called for zero growth, well above the actual figure. That forecast was made six weeks after the credit markets seized up in the wake of the failure of Lehman Brothers.

As for unemployment, in October the central tendency for the fourth quarter average was for a rate of 6.3 to 6.5 percent. The most pessimistic of the other members thought the rate could get up to 6.6 percent. It turned out the rate for October—the month that was ending as the forecast was made—was 6.6 percent. For the quarter, the average was 6.9 percent, and by December it was up to 7.2 percent.

There is clearly a recognition now that there is a crisis, but the Fed members still find it hard to believe that things will get much worse.