Fed changed wording as growth, inflation uncertain

A Federal Open Market Committee meeting in Washington, March 28, 2006. The Fed could yet raise interest rates if needed to quell inflation, but cut a reference to possible hikes from its March statement due to economic uncertainty, meeting minutes released on Wednesday show.

WASHINGTON (Reuters) - The Federal Reserve could yet raise interest rates if needed to quell inflation, but cut a reference to possible hikes from its March statement due to economic uncertainty, meeting minutes released on Wednesday show.

"The Committee agreed that further policy firming might prove necessary to foster lower inflation," minutes of the policy-setting Federal Open Market Committee's March 20-21 meeting said.

However, Fed officials decided that weaker-than-expected economic indicators combined with "uncomfortably high" readings on inflation suggested greater risks of slower economic growth as well as greater uncertainty that core inflation would recede as expected.

Doubts about the outlook caused the Fed to omit from the post-meeting statement language that exclusively pointed to possible interest rate increase.

"In the light of increased uncertainty about the outlook for both growth and inflation, the Committee also agreed that the statement should no longer cite only the possibility of further firming," minutes of the March meeting said.

FED DILEMMA

U.S. stocks extended losses on the day as the minutes were seen as suggesting more rate rises might be needed to hold inflation in check. The Dow Jones industrial average fell more than 89 points, or 0.7 percent.

Fed funds rate futures showed traders cutting prospects for a Fed rate cut by mid-year to 8 percent from 12 percent before the minutes.

"The Fed is still caught between a rock and a hard place; the rock is inflation the hard place is the slowing economy," said Paul Nolte, director of investments at Hinsdale Associates in Hinsdale, Illinois.

The Fed in March held interest rates steady at 5.25 percent and said inflation remained its predominant concern.

But the U.S. central bank also dropped language it used in previous statements saying that "the extent and timing of any additional firming that may be needed" would depend on what happened to the economy and to the outlook in the weeks ahead.

Instead, the Fed said that "future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth."

Markets rallied on the changed language, believing the Fed might be moving closer to cutting interest rates.

But the minutes showed Fed officials continuing to worry about stubbornly elevated inflation. Officials noted the latest readings on core inflation were higher than expected and might not moderate as hoped.

Policy-makers decided that holding interest rates steady was the best course to foster moderate economic growth and to bring core inflation down from "its elevated level."

"What this statement clarifies is that the possibility of rate hikes isn't totally discounted," said Doug Roberts, founder and chief investment strategist at Channel Capital Research in Shrewsbury, New Jersey.

SLUGGISH BUSINESS INVESTMENT

Even as they mulled inflation concerns, policy-makers believed surprisingly weak business investment and the rise of delinquencies in subprime mortgage markets posed new risks to the U.S. growth outlook.

"Additional evidence of sluggish business investment and recent developments in the subprime mortgage market suggested that the downside risks relative to the expectation of moderate growth had increased," the Fed said.

Fed officials said recent increases in prices for energy and some non-energy imports might boost overall inflation in the near term and might put some upward pressure on core prices. Tight labor markets added to worries that inflationary pressures could build.

At the same time, sparse business spending was perplexing in light of high profitability, favorable financial conditions and healthy corporate balance sheets, suggesting executives may be expecting only modest sales gains, the Fed said.

"Participants agreed that the possibility of persistently sluggish investment spending was an important downside risk to the outlook for economic growth," the Fed said.

The Fed said the rise in delinquencies among mortgages for borrowers with checkered credit could lead to higher interest rates and tighter credit standards, and might slow recovery of the downtrodden housing sector. But it did not see any spillover from the subprime mortgage market to the broader home loan market.