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Fed warns on economic outlook, and cites deflation fears

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Federal Reserve policymakers are expecting the economy to continue to contract through the first half of 2009, and possibly beyond that point, according to the minutes of their last meeting.

They also all but confirmed that they’ll cut their benchmark interest rate again, even though it’s already at a mere 1%.

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From the Oct. 28-29 meeting minutes, released today:

Participants generally expected the economy to contract moderately in the second half of 2008 and the first half of 2009, and agreed that the downside risks to growth had increased. While some expected an improving financial situation to contribute to a recovery in growth by mid-2009, others judged that the period of economic weakness could persist for some time. Participants saw the potential for financial strains to intensify if some investors, such as hedge funds, found it necessary to sell assets and as lending institutions built reserves against losses. Participants were concerned that the negative spiral in which financial strains lead to weaker spending, which in turn leads to higher loan losses and a further deterioration in financial conditions, could persist for a while longer.

As for the next likely move with interest rates:

Members anticipated that economic data over the upcoming inter-meeting period would show significant weakness in economic activity, and some suggested that additional policy easing could well be appropriate at future meetings. In any event, the committee agreed that it would take whatever steps were necessary to support the recovery of the economy.

The Fed also nodded to its fears about a potential broad-based deflation of prices: ‘Some saw a risk that over time inflation could fall below low levels consistent with the Federal Reserve’s dual mandate of price stability and maximum employment,’ according to the minutes. That’s code for deflation.

Some Fed officials felt that ‘more aggressive easing should reduce the odds of a deflationary outcome.’

The government today reported that the consumer price index slid 1% in October. Even excluding food and energy costs, the index was down 0.1%.

A little deflation is a good thing; a lot would be an economic catastrophe. Think Japan 1995-2005. See my recent column on deflation risks, here.


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