Although widely used economic barometers haven't yet signaled the formal beginning of a recession, there is a chance one lies ahead, Federal Reserve Bank of Richmond President Jeffrey Lacker said Tuesday.
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"Even if we get through this energy price bulge and inflation moderates, I'm still concerned of the overall pattern we've set," he said.
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Although risks to economic growth persist, Lacker said, "For us to lose substantial ground on inflation would be much more costly for us to remedy than for us to have to face a more substantial slowdown in growth than we've seen so far."
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"A 2% federal-funds rate with overall inflation running at 4% is an exceptionally low real interest rate - lower than we've had in the post-war record," he said. "Monetary policy seems quite stimulative to me on that basis."

"We can't sustain inflation at this pace," Lacker told reporters following at the Richmond Fed's Charlotte branch. "Moderation in growth by itself isn't likely to bring down inflation dramatically."

As reported by Reuters.

My own outlook for the rest of this year is for continued sluggish growth and weakness in labor markets. My 2008 forecast is for GDP growth of around 1.7 percent, which is near the upper end of the range of FOMC participants’ projections...The recent failure of IndyMac and the problems of Fannie Mae and Freddie Mac are the most recent events that have shaken confidence in our financial institutions and markets. This has raised the uncertainty surrounding forecasts for the economy, including my own. As I have said before, and as these recent events demonstrate, the road to recovery is likely to be a bumpy one.

Nevertheless, I continue to be generally more optimistic about 2009. As the housing market gradually completes its necessary adjustments and investors and the public regain confidence in financial markets, economic growth should return to its long-run trend of about 2¾ percent next year and the unemployment rate will gradually decline to about 5¼ percent by the end of 2009.

My outlook is that headline personal consumption expenditure (PCE) inflation will remain near 4 percent in 2008, reflecting in part the increase in energy prices. I expect core PCE inflation to be around 2½ percent this year.

In 2009, as energy and other commodity prices level off, I expect both measures of inflation to be lower — in the 2 to 2¼ percent range by the end of next year — provided we set monetary policy appropriately to restrain inflation and keep inflation expectations well-anchored.

I expect only modest improvement in the second half of this year, with GDP growth in a range of 1 to 1.5 percent.  Growth will be supported over this period by the fiscal stimulus from the tax rebates, from further strength in exports and government spending, and from the current accommodative stance of monetary policy.  Indeed, growth is likely to be relatively strong in the third quarter because of the rebates and then may soften noticeably in the fourth quarter.
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I am disappointedly, even less optimistic about the inflation outlook over second half of the year.  Indeed, I expect both overall and core inflation measures to rise further over the next several months.

While the growth outlook has improved since the beginning of the year, the inflation outlook has deteriorated. The latest figures confirm that inflation is unacceptably high. The price index for personal consumption expenditure increased 3.1 percent over the 12 months that ended in May, and is up at a 3.9 percent annual rate for the last 3 months. To put that in perspective, for several years, I have suggested an inflation target of 1.5 percent.

On the inflation front, the predominant problem so far has been soaring food and energy prices. Headline inflation is likely to remain much higher than I would like over the next few quarters. My best guess, which could easily be wrong, is that, consistent with futures prices, commodity prices will level off and cease to put direct upward pressure on headline inflation. Core inflation has been better contained, but has still been running a bit higher than I would like. In the next few quarters, I wouldn't be surprised if it runs modestly higher, as businesses pass some of their higher energy and transportation costs on to customers. By early next year, however, I expect that, assuming commodity prices level off, core as well as headline inflation will moderate, as more slack in labor and product markets emerges.

MR. LACKER. Yes. I notice that in chart 18, in your TIPS-implied average inflationary plot to the ten-year horizon, you omit the Markets Group’s estimate. Is that because of skepticism on your part that leads you to judge it as inferior or an overabundance of humility? [Laughter]

MR. DUDLEY. The latter, of course. [Laughter]

MR. LACKER. It does, of course, show a slightly different trend, right?

MR. DUDLEY. It actually has increased a bit. But I have consistently shown just the Barclays and Board measures over the past few months, so this is not “pick and choose.”

As the probability of severe damage to the financial system recedes, the likelihood of a measurable contraction in growth this year has lessened. These conditions complicate the inflation outlook, in which significant economic slack had been seen as helping to keep inflation in check.

Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly.  Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.  Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy.  However, the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside. 

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Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities.  Thus far, the pass-through of high raw materials costs to the prices of most other products and to domestic labor costs has been limited, in part because of softening domestic demand.  However, the continuation of this pattern is not guaranteed and future developments in this regard will bear close attention.  Moreover, the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations.  The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.

Thus far, the pass-through of high raw materials costs to domestic labor costs and the prices of most other products has been limited, in part because of softening domestic demand.  However, the continuation of this pattern is not guaranteed and will bear close attention...  Unfortunately, the prices of a number of commodities, most notably oil, have continued upward recently, even as expectations of future policy rates and the foreign exchange value of the dollar have remained generally stable in the past few months.  The possibility that commodity prices will continue to rise is an important risk to the inflation forecast.  Another significant upside risk to inflation is that high headline inflation, if sustained, might lead the public to expect higher long-term inflation rates, an expectation that could ultimately become self-confirming.

Over the past year, the economy has been buffeted by a series of shocks including financial turmoil; an emergency acquisition of a major investment bank to avoid a sudden, disorderly failure [Footnote 2]; falling national housing prices; and oil prices that have exceeded $130 a barrel. Despite all these challenges, the U.S. unemployment rate is at 5 percent; the rise in prices of “core” consumer goods and services (Personal Consumption Expenditures) to a little above 2 percent, while unwelcome, has not been large compared with past episodes; and the economy has been growing, albeit at a much slower pace then we would prefer. These relatively benign outcomes to date are at least partly the result of recent monetary and fiscal policy actions taken to mitigate some of the problems facing the economy.

If inflationary developments and, more important, inflation expectations continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic' [economy].

From Q&A as reported by Bloomberg News

Inflation expectations have remained reasonably well-anchored so far, which is encouraging -- but the key to maintaining low inflation and inflation expectations is likely to be the timeliness and the magnitude of decisions we make to reverse course.

We are highly sensitive to this issue and I am confident that we will conduct policy in an appropriate and timely manner.

As reported by Market News International and Reuters.

The implications of the headwinds for inflation are not so clear, although I would note that the pace of inflation diminished in the 1990s relative to its performance over the preceding several years.

As reported by Market News International.

Under these circumstances, I consider the current level of monetary accommodation to be appropriate. That, together with the fiscal package, should be sufficient to promote a step up to moderate economic growth later this year. Likewise, I would expect that inflation will moderate in coming quarters, as more slack in labor and product markets emerges and as commodity prices level off.  Of course, we will continue to monitor developments and act as needed to fulfill our mandate for sustainable economic growth and price stability.