Fed: Severe downturn possible

WASHINGTON Tue Apr 8, 2008 3:46pm EDT

The U.S. Federal Reserve Building is pictured in Washington, March 18, 2008. REUTERS/Jason Reed

The U.S. Federal Reserve Building is pictured in Washington, March 18, 2008.

Credit: Reuters/Jason Reed

WASHINGTON (Reuters) - Members of the Federal Reserve's policy-setting committee worried at their most recent meeting that housing and financial market stress could trigger a nasty slide in the economy, even as inflation pushed higher, minutes of the meeting released on Tuesday show.

"Some believed that a prolonged and severe economic downturn could not be ruled out given the further restriction of credit availability and ongoing weakness in the housing market," minutes of the March 18 meeting said.

Fed economists presented a somber picture of short-term prospects -- central bank staff now fully expect negative growth over the first six months of the year -- but held out the possibility of a modest rebound later.

"The staff projection showed a contraction of real GDP in the first half of 2008 followed by a slow rise in the second half," the report said, referring to gross domestic product, a broad measure of a country's output of goods and services.

At the same time, Fed officials found recent inflation reports "disappointing," noting also with concern that some indicators of inflation expectations were edging higher.

HARD TO SET POLICY

Policy-makers said there were limits to what could be done through interest rate cuts to deal with problems underlying the housing and financial market turmoil, but agreed trimming borrowing costs might provide some help.

However, Fed officials said it would be hard to calibrate policy responses because their aggressive rate cuts in recent months would take some time to show their effect on economic activity.

The Fed has cut U.S. overnight target interest rates by three percentage points to 2.25 percent since September.

Interest rates futures showed the implied prospects for the Fed to trim its benchmark lending rate by a half-percentage point in April, to 1.75 percent, rose toward 50 percent from 40 percent earlier, and 32 percent on Monday.

Rate futures now see a 1.75-percent funds rate as almost certain by the June meeting of the policy-setting Federal Open Market Committee, and have started to price in a chance that rates could be cut as low as 1.5 percent this year.

U.S. stocks .DJI .SPX .IXIC extended declines after the Fed minutes were released. Treasury debt prices gained as investors sought safety, and the dollar fell against the yen.

"Some of the words I see are a bit troubling," said Richard Sichel, chief investment officer at Philadelphia Trust Co in Philadelphia. "Some of their thoughts were maybe more negative than we might have believed at that point."

The Fed also said that while exports were getting a boost from a cheapening U.S. dollar, there also was a risk that the devalued greenback will further add to inflationary pressures from costlier oil and other commodities.

At the same time, slower global growth -- where major economies are also feeling the effects of financial turmoil and slower U.S. growth -- could limit the support exports have been providing, the central bank said.

WORRIED SETTING PRECEDENT

Faced with renewed deterioration in credit conditions in March, the Fed unleashed a rare string of special measures aimed at pumping liquidity into malfunctioning financial markets.

Minutes of a March 10 conference call that preceded announcement of a facility that made ultra-safe Treasury securities available to primary dealers in exchange for riskier assets showed policy-makers worrying that financial markets might grow dependent on special Fed liquidity actions.

"On balance, the committee decided that the facility could prove useful in preventing an escalation of an unhealthy dynamic that was developing in money and credit markets," the minutes said.

The minutes contain only a brief mention of the March 16 decision to approve the financing arrangement in which the Fed agreed to provide a $30 billion credit line backed by the shaky assets of troubled investment bank Bear Stearns BSC.N to facilitate that firm's acquisition by rival JPMorgan Chase (JPM.N).

The report explained why two members dissented from the March decision to cut rates by three-quarters of a percentage point. Both worried that more rate cuts could unhinge inflation expectations, which are critical to policy-makers because as long as expectations remain well anchored, the central bank can allow inflation to rise slightly while it lowers rates because markets believe inflation will soon be brought in check.

Dallas Fed President Richard Fisher believed the Fed should focus on liquidity measures to improve economic prospects rather than more rate cuts. Philadelphia Fed President Charles Plosser said the Fed could not afford to wait for clear evidence that inflation expectations have become unmoored because by then it would be too late to contain inflation pressures.

(Additional reporting by Jennifer Coogan in New York and Ros Krasny in Chicago; Editing by James Dalgleish)