Fed likely to give investors a surprise

The US Federal Reserve will on Tuesday publish its first set of enhanced economic forecasts alongside the minutes of the last meeting of the Federal Open Market Committee, and the result may surprise some investors.

The new economic projections are likely to show that Fed policymakers expect the US economy will pull through an expected near-term rough patch and regain strength over the course of 2008, even though they see downside risks to that ­forcast.

This relatively upbeat assessment will reinforce the impression that the US ­central bank is more bullish on growth than the financial markets, and challenge market expectations of further interest rate cuts.

Fed funds futures are pricing in a near-90 per cent probability that the Fed will cut interest rates again in December, and the market expects the central bank will ­probably cut rates twice more during next year – a base case view top Fed officials apparently do not share.

The projections themselves will not offer a clear picture of the likely path of interest rates, because they are made by each policymaker individually on the assumption of appropriate monetary policy.

But the minutes to be published alongside the projections will show that at the time of the October meeting – when the projections were made – most Fed officials were not expecting to cut interest rates further.

Taken together, the two are likely to suggest the Fed does not think that further aggressive rate cuts are likely to prove necessary to underwrite the expected recovery in growth.

The caveat is that the projections were made on October 31 and credit market conditions have deteriorated since then. However, recent comments by Fed officials suggest that they do not regard these changes as significant enough to shift their policy stance.

The new forecasts will also lift the veil on Fed thinking about a range of important longer-term economic issues.

They will demonstrate once and for all that the Fed does not have an agreed “comfort zone” for inflation of between 1 per cent and 2 per cent when measured by the personal consumption expenditure deflator – as some in the markets still believe.

Instead they will probably show that most Fed officials target a number in the higher end of that range – perhaps between 1.5 per cent and 2 per cent – because of the risks associated with very low inflation.

The projections will also probably show that, while some Fed officials think food and energy prices will rise faster than others in the years ahead, most do not.

They will demonstrate that Fed policymakers now see US trend growth as slightly below 3 per cent, with most officials probably estimating trend to be somewhere in the region of 2.8 per cent, but some possibly seeing it lower than that.

Meanwhile, they will indicate that the Fed is not very sure what the lowest sustainable rate of unemployment is, seeing it as somewhere between 4.5 per cent and 5 per cent.

These insights were already implicit in existing Fed communications, but will become much clearer with the publication of the new forecasts and the accompanying commentary.

● A National Association of Business Economists survey suggests most economists still think the economy will recover next year without the help of further Fed rate cuts. The median forecast is for 2.6 per cent growth next year, with rates on hold at 4.5 per cent throughout 2008.