Evolution of Fed's Economic Views--to be Updated Tomorrow

The Federal Reserve holds a two day meeting that concludes near midday tomorrow. It will likely be the first meeting in a while where there is not change in the composition or size of the balance sheet and no fresh initiatives, like cutting the rate of interest paid on excess reserves, or guidance. The tweaks in the communication are likely to be modest at best.

There is some talk that the Fed will announce renewed MBS purchases, but we are not convinced the Fed is there. Clearly increasing the balance sheet remains an option that the Fed refuses to reject. We expect the option not to be exercised unless there is a material risk of a renewed US economic contraction or that the risks of deflation increase markedly.

However, two elements of the FOMC meeting prevent us from arguing it is a non-event.

First, it is followed by a press conference by the Chairman. This is a relatively new developments and the medium is still being explored. The press conferences have been used by Bernanke as an accessibility and education exercise.

The second is more important. The Fed's staff provides updated economic forecasts. There has been a clear trend toward cutting growth forecasts and raising inflation forecasts. That trend is likely to remain intact with tomorrow's forecasts. This largely reflects information that has become available since the last forecasts in June.

Back in January, the staff forecasts had the economy expanding 3.4-3.9% this year and 3.8-4.4% next year. Both forecasts were cut in April and June. In June, growth this year was estimated at 2.7-2.9% and 3.3-3.7% in 2012. Tomorrow the staff will likely acknowledge US growth this year will not exceed 2.0% and next year's growth estimate is likely to be cut around 1 percentage point to 2.3-3.5%.

At the start of the year, the Fed's staff that unemployment would fall to 8.8-9.0%. In April and June the forecast were cut to below 9%. In June the forecast was for 8.6-8.9%. The Fed's staff is likely to raise it back above 9% for this year. Forecasts for next year's unemployment has gradually increasing. In June it stood at 7.8-8.2%. This still seems unduly optimistic. It should not be surprising to see the staff revise up toward 8.5-8.8% next 2012 unemployment.

In January the Fed staff expected the core PCE deflator would rise 1.0-1.3% this year. They have gradually lifted its forecast so it June it too at 1.5-1.8%. This may be nudged a touch higher tomorrow. The core PCE deflator for next year began 2011 at 1.0-1.5%. In June, the Fed's staff was looking for 1.4-2.0% in 2012. We suspect the Fed may tweak this to show more potential for lower rather than higher inflation.

Even if our assessment of the Fed statement and lack of new action is correct, there still is scope for a couple of dissents. Fisher and Plosser are the likely suspects. Kocherlakota has suggested he is not a serial dissenter, so it is possible that he may not dissent.