by Calculated Risk on 1/07/2008 02:27:00 PM

From Atlanta Fed President Dennis P. Lockhart: The Economy in 2008

Looking to 2008, I believe the pivotal question—the central uncertainty—is the extent of current and future spillover from housing and financial markets to the general economy. The dynamics I'm watching—stated simplistically—are the following. First, there's the effect of dropping house prices on the consumer and in turn on retail sales and other personal expenditures. And second, I'm watching the effect of financial market distress on credit availability and, in turn, on business investment, general business activity, and employment.

This is exactly what we've been following and trying to quantify: the impact of declining home prices on the economy (especially consumer spending), and the impact of less non-residential investment.

My base case outlook sees a weak first half of 2008—but one of modest growth—with gradual improvement beginning in the year's second half and continuing into 2009. This outcome assumes the housing situation doesn't deteriorate more than expected and financial markets stabilize. A sober assessment of risks must take account of the possibility of protracted financial market instability together with weakening housing prices, volatile and high energy prices, continued dollar depreciation, and elevated inflation measures following from the recent upticks we've seen.

Lockhart will probably be "surprised" by housing once again.

I'm troubled by the elevated level of inflation. Currently I expect that inflation will moderate in 2008 as projected declines in energy costs have their effect. But the recent upward rebound of oil prices—and the reality that they are set in an unpredictable geopolitical context—may mean my outlook is too optimistic. Nonetheless, I'm basing my working forecast on the view that inflation pressures will abate.

My interpretation: "I'm worried about inflation, but I'm voting for a 50bps rate cut in January." (update: Lockhart is an alternate member at the January meeting)

To a large extent, my outlook for this year's economic performance hinges on how financial markets deal with their problems. The coming weeks could be telling. Modern financial markets are an intricate global network of informed trust. Stabilization will proceed from clearing up the information deficit and restoring well-informed trust in counterparties and confidence in the system overall.

To restore market confidence, leading financial firms, I believe, must recognize and disclose losses based on unimpeachable valuation calculations, restore capital and liquidity ratios, and urgently execute the strenuous task of updating risk assessments of scores of counterparties. The good news is that markets can return to orderly functioning and financial institutions can be rehabilitated quickly. With healthy disclosure, facing up to losses, recapitalization, and the resulting clarity, I believe there is hope for this outcome.

This sounds good, and I agree that financial firms should disclose their losses, but - with falling house prices - no one really knows how large those losses are going to be. Until we get a handle on how far prices will fall, we can't really pin down the losses to the financial institutions.