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NEW YORK - The US Federal Reserve and financial markets seem to be sharply at odds over where the economy and interest rates are heading, and fresh Fed forecasts to be released tomorrow are unlikely to bridge that gap.
Fed policy-makers have indicated they expect the economy to claw its way back to relative health at some point next year, and that the current setting of interest rates is likely well positioned to help it to do so.
More detailed and extensive forecasts to be released by the US central bank tomorrow are likely to underscore that view.
But many financial market participants and some top economists expect the persistent housing slump, cooler spending and continued turmoil in financial markets to weigh more heavily on the economy, perhaps even triggering a recession.
"The new forecasts will not converge but rather confirm the divergences that there are between the markets and the Fed," said Michael Feroli, economist at JPMorgan in New York.
Prices for US government debt rose in a safe-haven bid on Monday as stocks fell on credit concerns and traders raised bets on interest-rate cuts.
Since mid-September, the Fed has lowered the benchmark federal funds rate by a cumulative three-quarters of a percentage point to prevent economic fallout from financial turmoil sparked by losses in the US subprime mortgage market. The target for overnight rates now stands at 4.5 per cent.
Futures markets have moved to price in a near certainty of another quarter-point reduction at the next Fed meeting on December 11, a 64 per cent implied chance of a cut to 4 per cent in January, and about a 28 per cent chance of a cut to 3.75 per cent in March.
Harvard University professor Martin Feldstein, who said in late August the Fed would have to ease by a full percentage point, said on Monday the central bank would have to lower rates by at least another quarter-point in December and more next year to stave off a recession.
"The Fed has to move the federal funds rate to some number beginning with 3, not 4," he said at the Council on Foreign Relations, adding that downside economic risks were larger now than they had appeared in August.
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Wall Street also has been reassessing its view, and appears to be moving further away from the Fed, not closer to it.
"We can easily imagine having to make room for more rate cuts than we are currently forecasting if the news on the economy and the markets stays as troubling as it has been lately," Goldman Sachs economists said in a recent research note. Goldman currently expects the federal funds rate to reach 4 per cent by the end of the first quarter.
In unusually direct comments on Friday, Fed Governor Randall Kroszner said more rate cuts did not appear warranted, even though growth looked set to weaken in the near term.
"The current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate," he said.
Other policy-makers have offered a similar, if less direct, message, with little impact on market expectations.
JPMorgan changed its Fed call late last week, saying it now expected a quarter-percentage point cut in both December and January due to growing downside risks to the economy. It had previously thought the Fed would be on hold at both meetings.
Allan Meltzer, a professor at Carnegie Mellon University, said the markets had forced the Fed's hand to lower rates last month and it appeared they would do so again in December.
"As the market has priced in a cut, the Fed is where it was" before its last meeting, he said, speaking at the Council on Foreign Relations with Feldstein.
High oil prices, which have hovered below US$100 a barrel, would dampen consumer spending but the Fed could do little about that directly, he said, adding that he thought the economy would avoid recession nevertheless.
On Tuesday, the Fed will have another chance to bring markets closer to its view. Along with minutes of its last rate meeting on October 30-31, it will release updated forecasts from Fed policy-makers.
In the past, the central bank released such forecasts twice a year, but on Tuesday it will begin releasing them quarterly and in an expanded format that will provide more detail on how officials view the outlook.
- REUTERS
