In the six weeks since the last meeting of the Federal Reserve’s Open Market Committee (FOMC), there has been a further material weakening in the U.S. economy and renewed strains on the U.S. financial system. At the same time, there has been an abrupt weakening in labor market conditions and an unprecedented deceleration in inflation that raises anew concerns about a deflationary spiral.

At its forthcoming meeting January 27-28, the FOMC will in all likelihood reiterate its commitment to maintaining an exceptionally low federal funds rate for an extended time period. The FOMC will also most likely move further in the direction of formal inflation targeting and will provide additional indications of how it plans to further use the Federal Reserve’s balance sheet to support credit markets and economic activity.

Here are some of the key economic indicators that the FOMC will be considering in formulating monetary policy:

1. Employment conditions continue to deteriorate rapidly. In December, the U.S. economy again lost more than 500,000 jobs, raising the jobs lost in 2008 to over 2.5 million. 

2. Labor market and output gaps continue to widen, which must be expected to exert considerable downward pressure on wages and prices. The unemployment rate rose from a cyclical low of 4.5 percent to 7.2 percent by December 2008 and is likely to rise towards 9 percent by the end of 2009.

3. Deteriorating labor market conditions and falling asset prices have contributed to a collapse in consumer confidence to its lowest level in 25 years.

4. Consumer spending, which accounts for around 70 percent of GDP by expenditure, is dropping at its fastest rate since World War II. 

5. Industrial production is declining at its fastest pace in 30 years.

6. Housing starts have plumbed new lows, while housing permits suggest no sign of stabilization in the housing market.

7. Over the past three months, consumer prices have decelerated at their fastest pace in the post-war period.  

In the context of a significant weakening in the U.S. economy, it is likely the FOMC will make clear in its statement that it considers that inflation risks have further receded, while the downside risks to the economy have increased. Having exhausted the room for additional reductions in the federal funds rate, the Fed will now give additional indications as to how it plans to further use its balance sheet to support the economy and the financial system. One might also expect that the FOMC will give serious consideration to the adoption of a formal inflation target with the intention of signaling its firm determination to avoid deflation.

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.