Since the Federal Open Market Committee’s last meeting in January, there has been a significant deterioration in the U.S. economic outlook and a further substantial decline in U.S. equity prices. In his recent semi-annual congressional testimony, Federal Reserve Chairman Ben Bernanke indicated that the Fed had significantly downgraded its 2009 economic forecast. The Federal Reserve now expects that GDP will decline by between 0.5 percent and 1.5 percent in 2009, unemployment will rise to between 8.5 and 8.75 percent, and inflation will moderate to between 0.25 and 1 percent for the year. Bernanke also cautioned that resolving the financial sector crisis was a necessary condition for a sustained economic recovery.

At its forthcoming meeting on March 17 and 18, the FOMC will more than likely acknowledge the heightened downside risks to the U.S. economic outlook and the need to be alert to the dangers of deflation. One should expect that the Fed will reiterate that it expects to keep the federal funds rate at close to zero for a prolonged period of time and that it will intervene as necessary in the mortgage-backed securities market and in the U.S. Treasury bond market to forestall the onset of deflation.

One might also expect that the Fed will indicate that it is considering expanding existing relief programs or that it will come up with new ones to extinguish the worst financial crisis since the 1930s. A further possibility is that the Fed will move closer to a formal inflation target as a signal to markets of its determination to avoid a deflationary trap.

The FOMC will be looking at the following indicators that heighten its concern about the downside risks to the U.S. economy:

• Overall output is contracting at the fastest pace since the 1982 recession. In the last quarter of 2008, real GDP contracted by 6.2 percent. It is now widely expected that GDP is declining by between 5 and 6 percent in the first quarter of 2009.

 
 
• Employment has been declining by more than 600,000 jobs a month, or at the fastest pace since the 1982 recession. At the same time, unemployment has risen to 8.1 percent.

 
• There is no indication of any stabilization in U.S. housing prices, which continue to decline nationally at their fastest pace in the postwar period.

 
 
• Equity prices have declined by over 20 percent since the beginning of the year, thereby further undermining consumer confidence.

 
 
• Consumer confidence has declined to its lowest level in the postwar period in reaction to heightened job-insecurity and falling housing and equity prices.

 
• Retail sales continue to decline at a rapid pace.

 
• Headline price inflation has now declined close to zero, while core price inflation, excluding food and energy prices, has decelerated to 1.75 percent.

 
• International oil prices remain at moderate levels, which would be consistent with headline inflation becoming negative in coming months on a twelve month basis.

 
• There has been a significant appreciation in the U.S. dollar over the past three months, which should further help keep headline inflation well contained.

 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was managing director and chief emerging market economic strategist at Salomon Smith Barney and a deputy director in the International Monetary Fund’s Policy and Review Department.

Image by Darren Wamboldt/The Bergman Group.