While it may have asserted that its end-October rate-cut decision was a "close call", the minutes of the Fed meeting and its new quarterly policy statement predict lower growth and leave the door wide open for further rate cuts.

The minutes from the 30 and 31 October meeting of the Federal Open Market Committee (FOMC), the Federal Reserve''''s policy-setting arm, have turned out to be more cautious on the outlook for US growth than the country''''s financial markets expected; all in all, it predicts a weaker economy and higher unemployment than previously expected.
That''''s the bad news. There''''s a silver lining too; inflation is likely to be lower in 2008 than in 2007, and it is expected to fall in subsequent years. The central bank didn''''t give any indications on whether it would cut the benchmark interest rate in the near future. But Fed watchers remain convinced that lower rates are on the horizon because of the gloomy outlook.

New forecasting system
In releasing the minutes of the FOMC''''s October meeting, the Fed provided a first look at its new economic forecasting system, designed to provide investors with more insight into the central bank''''s thinking.

Predictions for economic growth, unemployment and inflation will now be released four times a year instead of two. And the forecast will also look three years into the future instead of two. Fed chairman Ben Bernanke announced the changes in a speech at the Cato Institute last week.

The Fed had said the decision last month to cut its benchmark rate by a quarter per cent - to 4.5 per cent from 4.75 per cent - was a "close call", mainly as insurance against weak economic conditions. But both the FOMC policy statement and the minutes of the 31 October meeting, both released on Tuesday 20 November, suggest risks are tilted to the downside on growth.

So, despite the Fed''''s Halloween "close call" assessment, bond market bulls have pounced on its projections of slower growth even with the recent rate cuts. Market movers feel this suggests that the Fed''''s "balanced" risk assessment may be tipping toward slower growth and, therefore, a more relaxed policy stance.

More "close calls" to come?
In fact, some analysts are predicting even faster and deeper rate cuts. Paul McCulley, a fund manager at Pacific Investment Management Co (Pimco), says the Fed may reduce its target interest rate to below 3 per cent to keep the US economy from lapsing into recession.

"In their heart of hearts, their big concern is that this economy has a fat-tailed risk of recession," McCulley said. A unit of Munich-based insurer Allianz SE, Pimco managed $720.6 billion in assets as of 30 September.

Interest-rate futures traded on the Chicago Board of Trade show traders see 94 per cent odds that policy makers will reduce rates to 4.25 per cent on 11 December, compared with 76 per cent odds before the minutes were released.

"A low three-handle is a done deal," McCulley said. He felt even a "two-handle" was possible, particularly if the Fed delays rate cuts. The longer the Fed delays in getting aggressive in easing interest rates, the lower the ultimate fed funds rate will be, McCulley concluded. A "three-handle" is bond market jargon for interest rates between 3 per cent and 4 per cent.

Downward bound
In its forecast, the Fed said real growth in gross domestic product (GDP) for 2008 is likely to be 1.8 per cent to 2.5 per cent, down from a June prediction of 2.5 per cent to 2.75 per cent. It also revised its unemployment forecast for the fourth quarter of 2008 to as much as 4.9 per cent, up from a previous prediction of 4.75 per cent.

These economic benchmarks clearly suggest the country is in for a slowdown, "owing primarily to weakness in housing markets and to the tightening in the availability of credit resulting from recent strains in financial markets", the Fed said.

In recent weeks, many banks, including Merrill Lynch, Citigroup and Bank of America, have announced billions of dollars in write-downs owing to their exposure to shaky mortgage-backed securities. The Fed said it expects unemployment and GDP growth to return to normal levels by 2010.

Inflation imperative
The Fed has high-balled inflation, relative to what might be expected given that these figures can be interpreted as the first statement of the Fed''''s real inflation objective. "Inflation targeting", is a policy tool practiced by many other central banks (including the European Central Bank) that is meant to give guidance to investors by explicitly stating what is an acceptable level of inflation. Bernanke has long favoured an inflation target, but his predecessor, Alan Greenspan, opposed the practice, arguing that it didn''''t leave the economy enough wiggle room, should an unexpected shock occur.

Fed rhetoric often suggests a 1 per cent to 2 per cent "comfort zone" for inflation as measured by the personal consumption expenditure chain price index. Policymakers ought to generate forecasts consistent with that range. But the general tendency shows that both headline and core inflation hover around only the upper half of that band. The Fed forecasts a decline in headline inflation from the 3 per cent zone to the 1.6 per cent to 1.9 per cent range by 2010. It would appear, therefore, that the real "comfort zone" is between 1.5 per cent to 2 per cent.

Some Fed watchers have described the new forecasting guidelines as "inflation-targeting lite", because they essentially reveal the central bank''''s thoughts on inflation, allowing it to revise its predictions four times a year.

Room for surprises
The relatively low growth estimates for 2007 and 2008 suggest that ''''surprises'''' in economic data after 31 October can still be absorbed into the existing figures without easing the policy stance, even if growth prospects are further downgraded.

The GDP numbers for 2007 are already below market forecasts in data since October. Third-quarter GDP gain looks poised for nearly a 1 per cent upward revision in the next report, so the Fed''''s 2.4 per cent to 2.5 per cent prediction for 2007 would require a fourth-quarter GDP gain of just 0.5 per cent to 0.9 per cent, well below most market forecasts. The 2.3 per cent to 2.7 per cent prediction for 2008 leaves room for a weak first quarter as well.

Soaring oil prices imply that inflation will outpace the Fed''''s personal consumption expenditure (PCE) assumption for 2007 of a 2.9 per cent to 3.0 per cent increase, as this would require a fourth-quarter PCE chain price gain of only 2.1 per cent to 2.5 per cent, versus the generally expected our 3.1 per cent forecast. Core inflation is on track, however, at 1.7 per cent to 1.9 per cent.

The door stays open
The interplay between of what the Fed says in the minutes - and its estimates for future growth - actually leaves the door wide open for further rate cuts ahead. The market is making its own forecasts in that area! Trading in Fed funds futures - through which market pros make bets on future interest rate moves - on Tuesday showed that investors overwhelmingly expect a quarter-point interest cut when Bernanke''''s Fed next meets in December.

The new guidelines seem to suit the investors. The Dow Jones, Nasdaq and S&P 500 indexes all finished slightly higher for the day. And now that the Fed has a clearer picture on three of the most important indicators for the economy - GDP growth, unemployment and inflation - can it help dig the US out of its current economic woes? The forecasts may have opened out the Fed''''s thinking to the financial world, but the central bankers can''''t really predict the future.