updated 11/20/2007 4:54:25 PM ET 2007-11-20T21:54:25

The housing collapse and credit crisis will slow economic growth and nudge up unemployment next year, the Federal Reserve said Tuesday in a first-of-its-kind forecast that some economists believe will lead to interest rate cuts early in 2008.

Major Market Indices

Don’t count on a cut in rates at the Fed’s December meeting, however, analysts say. The Fed called its rate reduction in late October a “close call” and hinted that its two cuts this year may be sufficient to energize the economy, according to minutes of the Oct. 31 closed-door meeting made public Tuesday.

Policymakers raised concerns at that meeting that inflation might flare up again in the short term, especially in the face of rising energy prices.

But with the Fed’s longer-term forecast calling for moderating inflation next year and beyond, economists believe the central bank will have leeway to reduce rates next year.

“The economy is walking on a high wire. Eventually the Fed will have to cut rates again to put a net or a cushion under a falling economy,” said Stuart Hoffman, chief economist at PNC Financial Services Group. He and other economists predicted more rates cuts early next year to prevent the possibility of the economy falling into a recession.

On Wall Street, the Dow Jones industrials gained ground after the Fed issued its forecast and minutes of the October meeting. The Dow Jones industrials were up more than 50 points.

The Federal Reserve, in the first of its quarterly economic reports to the nation, said it believes business growth will slow next year, with the gross domestic product gaining between 1.8 percent and 2.5 percent. That would be weaker than how the Fed expects the economy to perform this year and would mark a downgrade to a previous projection released in the summer.

GDP is the value of all goods and services produced within the United States and is the best barometer of the country’s economic fitness.

The downgrade to GDP was due to a number of factors, including “the tightened terms and reduced availability of subprime and jumbo mortgages, weaker-than-expected housing data and rising oil prices,” the Fed explained.

The credit crunch has made it both more costly and more difficult for people and companies to borrow money. The worst carnage has taken place in the market for subprime home loans — those made to people with spotty credit histories. Credit problems started there and have spread to more creditworthy borrowers, including those who are looking for home loans of more than $417,000, so-called jumbo loans.

The big worry is that these housing and credit problems will make people and businesses less inclined to spend, dealing a larger-than-expected blow to national economic growth.

“The possibilities that markets could relapse or that current tighter credit conditions could exert unexpectedly large restraint on household and business spending were viewed as downside risks to economic activity,” the Fed said in its quarterly forecast. “Participants were concerned about the possibility for adverse feedbacks in which economic weakness could lead to further tightening in credit conditions, which could in turn slow the economy further.”

T.J. Marta, fixed income strategist at RBC Capital Markets, said he expects “negative developments in financial markets will tip the Fed toward easing” interest rates by the first quarter of next year.

With economic growth slowing, the unemployment rate would rise to between 4.8 percent and 4.9 percent next year — still low by historical standards. A previous forecast estimated the unemployment rate next year would be about 4.75 percent. For all of last year, the jobless rate dipped to 4.6 percent, a six-year low.

The Fed said the “unemployment rate would increase modestly” in 2008, stabilize in 2009 and then decline slightly in 2010.

Overall inflation should ebb next year to between 1.8 percent and 2.1 percent. Inflation should moderate further in 2009 and 2010, the Fed said.

“Overall inflation was expected to edge down over the next few years, fostered by an assumed flattening of energy prices,” the Fed said.

So far, surging energy prices this year haven’t touched off a major inflation problem throughout the economy.

Oil prices last week hit a record high of $98.62 a barrel. They have ebbed a bit and are hovering above $96 a barrel. Gasoline prices have topped $3 a gallon.

The Fed’s forecasts are based on estimates of activity in the final quarter of one year compared with the same period of a previous year.

Meanwhile, the central bank’s decision on Oct. 31 to slice interest rates for a second time this year to combat housing and credit troubles was not necessarily an easy one for Fed officials.

“Many members noted that this policy decision was a close call,” the minutes revealed.

In the end, Fed Chairman Ben Bernanke and all but one of his colleagues agreed to lower its key interest rate by a one-quarter percentage point to 4.50 percent. It marked the second rate reduction in six weeks.

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, was the sole dissenter at the meeting. He preferred no change in the funds rate. The smaller, October rate cut followed up a bolder, half percentage-point reduction in September, the first time the Fed had lowered its key rate in more than four years.

The decision to cut rates last month was seen by most Fed officials as a way to protect the business climate against the possibility that these problems could worsen and throw the economy into a recession.

“Most members saw substantial downside risks to the economic outlook and judged that a rate reduction at this meeting would provide valuable additional insurance against an unexpectedly severe weakening in economic activity,” the minutes said.

Moreover, many Fed policymakers believed the rate cut could help calm still-fragile financial markets. Wall Street has been suffering through an especially turbulent period over the past several months due to the spreading credit troubles and the deepening housing slump.

Tuesday’s economic forecast was a fulfillment of Bernanke’s pledge to bring more openness to an institution that historically has been enshrouded in secrecy.

It marked the biggest move yet by Bernanke to put his imprint on the Fed, which he has been running since February 2006.

Alan Greenspan, Bernanke’s predecessor, made progress on that front in his 18½ years, but Bernanke has sought to pry the door open even further, providing investors, businesses and individuals with more insights into the thinking of Fed policymakers.

Doing that helps the Fed do its job — keeping the economy and inflation on an even keel.

Improving the public’s understanding of the Fed’s objectives and strategies reduces uncertainty, allowing businesses and people to make more informed financial decisions. If investors have a better understanding of how Fed policy is likely to respond to incoming information, stock prices and bond yields will tend to respond to economic data in ways that further the central bank’s objectives.

Bernanke last week announced steps to bring greater openness to the institution that historically has substantially operated behind closed doors. With Tuesday’s report, the Fed is now releasing quarterly economic forecasts, versus twice-a-year projections. The Fed is also saying what it thinks the business environment will be for the following three years, not two. The Fed also is giving unprecedented detail into policymakers’ thinking into the economy’s outlook and the risks facing it.

A research paper released Tuesday by Fed drove home the point that forecasting is as much an art as it is a science.

“If past performance is a reasonable guide to the accuracy of future forecasts, considerable uncertainty surrounds all macroeconomic projections” — including those of Fed policymakers — the paper said.

© 2013 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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