The US Federal Reserve expects the US economy to grow sluggishly next year and says risks are on the downside according to forecasts issued on Tuesday. The Fed also published the minutes of the October meeting of the interest rate setting Federal Open Market Committee (FOMC), which showed that the decision was a close call.

The Fed said on Tuesday that it expects food and energy prices to continue putting upward pressure on inflation, but underlying inflation is now, and will remain, within the target range implied by their new forecast.

The Fed showed that it no longer believed the US economy can grow much more than 2.5% a year without causing rising inflation, a lower rate than many investors thought was sustainable.

The downbeat assessment of long-term growth potential growth helps explain why the US central bank appears reluctant to cut interest rates too aggressively in the face of low growth.

The Fed indicated that it intends to target inflation of 1.6-1.9% on its preferred measure, the personal consumption expenditure deflator. The estimates were contained in the first set of enhanced economic forecasts published by the Fed. The 1.75% midpoint of this range is higher than that of the 1% to 2% comfort zone that was promoted in 2002 by Ben Bernanke, then a Fed governor and now Fed chairman.

The new forecasts are seen as keeping open the option of cutting rates again in coming months. However, the minutes of the  FOMC's Oct. 30-31 meeting, which ended with a decision to cut the target for the Fed's key interest rate to 4.5% from 4.75%, show that the decision to cut rates, as opposed to leaving them unchanged, was a "close call."

The Fed issued a  statement after the October meeting saying risks of weaker growth and higher inflation were balanced. In the interval, policymakers have signalled that a rate cut is not envisaged at the Dec 11th meeting. But the markets are expecting another quarter-point rate cut next month. The forecasts may bolster those hopes, because they reinforce the impression that despite the Fed's officially neutral stance, it is, in fact, worried more about growth than inflation.

In the FOMC minutes, the rate cut was described as "significant valuable insurance against an unexpectedly severe weakening in economic activity." By describing the cut as "insurance," the minutes suggest that the outlook, by itself, didn't call for more rate cuts.

Most FOMC of the members saw US gross domestic product growing next year by between 1.8% and 2.5%, down from their June projection of 2.5% to 2.75%. The ranges represent the forecasts of all 17 members minus the three highest and three lowest forecasts.

The minutes, and a study by Fed staff economists David Reifschneider and Peter Tulip, emphasise that projections are subject to significant forecasting error, and those errors grow the further the forecast goes into the future. Based on the track record of forecasts, they say there's a 70% chance growth will be 1.3 percentage points higher or lower than the FOMC forecasts next year, and 1.4 points higher or lower in subsequent years.

Housing Slump to Worsen

The Wall Street Journal reports that US Treasury Secretary Henry Paulson, concerned that millions of homeowners aren't being helped quickly enough, is pressing the mortgage-service industry to help broad swaths of borrowers qualify for better loans instead of dealing with mortgage problems on a case-by-case basis.

In an interview, Paulson said the number of potential home-loan defaults "will be significantly bigger" in 2008 than in 2007. He said he is "aggressively encouraging" the mortgage-service industry -- which collects loan payments from borrowers -- to develop criteria that would enable large groups of borrowers who might default on their payments to qualify for loans with better terms.

Prof. Peter Morici wrote in the Kansas City Star on Tuesday:  Over the next 18 months, 2 million adjustable-rate mortgages will reset to higher interest rates, and many homeowners cannot afford the payments. Without viable refinancing options, many homes will go on the market. The negative consequences for consumer spending and unemployment are obvious.

Federal Reserve Chairman Ben Bernanke is encouraging financial institutions to exercise forbearance in restructuring adjustable mortgages, but many cannot be reworked because of the covenants in mortgage-backed bonds. These loans must be refinanced, but new loans cannot be written because the market for mortgage-backed bonds has evaporated.

Investment banks that bundle mortgages into bonds get higher interest rates and larger profits when bond rating agencies conservatively estimate risks of default. These investment banks, not investors, hire and pay rating agencies creating ruinous conflicts of interest.