Three "D"s: Biggest risks from FOMC minutes

Declines. The minutes showed that the FOMC members were surprised at the "significant contraction in economic activity in the fourth quarter." Choose your aggregate variable, and it went down--GDP, employment, industrial production, investment, housing, overall prices, stock market, trade. The FOMC forecast from the meeting was a substantial decline of real GDP in Q42008, sharply downward revised estimates of economic activity in 2009 with declines in 2009's first half and very slow growth in 2009's second half, and moderate recovery in 2010. "...[T]he severe ongoing financial market strains, the large reductions in household wealth, and the global nature of the economic slowdown were seen by some participants as suggesting the distinct possibility of a prolonged contraction, although that was not judged to be the most likely outcome."

Deflation. "The Committee noted that, in light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, it expected inflation to moderate in coming quarters to levels consistent with price stability." However, I don't know how to reconcile that statement with the following statement that appeared later in the minutes. "Core inflation was projected to slow considerably in 2009 and then to edge down further in 2010." Core inflation, as measured by the CPI, is currently at 0% growth. Any declines would be considered deflation. As I have noted in previous posts (post 1 and post 2), deflation should be the prime worry of the Federal Reserve. "Some [FOMC members] saw inflation leveling out near desired levels, while others expressed concern that inflation might decline below levels consistent with price stability in the medium term."

Division. The FOMC minutes revealed some division among the committee members about the new "quantitative easing" instruments that the Fed is resorting to, now that the federal funds rate has been lowered to its minimum. The debate seemed to hinge on whether or not to establish quantitative targets for things like excess reserves. As I in a previous post, we are in uncharted territory, and these discussions from the last FOMC meeting demonstrate that the Fed doesn't exactly know the best way to proceed in this new quantitative easing route.

In summary, it looks like the U.S. will likely be in a recession through 2009 (see Menzie Chinn, Econbrowser post), and I think the core CPI numbers on January 16 and in February will be a big indicator of whether the economic stimulus from the Fed and Congress will restore growth in 2009.