REFILE-UPDATE 2-Fed saw weak US growth, financial stress-minutes

(Fixes 3rd paragraph to clarify minutes released on Tuesday) (Adds details, fresh analyst quotes)

By David Lawder

WASHINGTON Aug 26 (Reuters) - Federal Reserve monetary policy-makers this month saw a weakening economic outlook and financial market stress as supporting the case for steady interest rates despite persistent concerns about inflation.

At their latest policy meeting on Aug. 5, members of the rate-setting Federal Open Market Committee agreed that softening labor markets, high energy prices and a continuing housing contraction would weigh on future growth, leaving U.S. economic activity "damped" for several quarters.

"In addition, members saw continuing downside risks to this outlook, particularly reflecting possible further deterioration in financial conditions," the Fed said in minutes of the meeting released on Tuesday.

While the members agreed the next policy move would likely be an increase in rates, most of them did not see the Fed's current monetary stance as "particularly accommodative," because households and businesses were facing tighter credit and higher borrowing costs.

The meeting ended with the Fed keeping its benchmark federal funds rate unchanged at a low 2 percent, where it has been since April, when the U.S. central bank paused a six-month rate-cutting campaign.

At the same time, FOMC participants said inflation was expected to moderate in coming quarters, reflecting a "leveling-out" of energy and commodities prices.

"Although measures of core inflation might well edge up later this year, given the pass-through to final goods prices of earlier increases in the prices of energy and other inputs, most participants anticipated that core inflation would edge back down during 2009," the Fed said.

Market reaction to the minutes was muted as analysts said they reinforced views that Fed policy remained on hold. U.S. Treasury debt prices remained weaker and stocks fell, also hurt by higher oil prices and continued worries about the financial sector. The dollar held steady at higher levels.

"The Fed is on hold and the minutes verify that. That's ultimately good news for equities and bad for bonds. We may not see it today, but that's been the message they've been sending in the past month or so," said Kurt Karl, chief U.S. economist at Swiss Re in New York.

U.S. short-term interest rate futures showed a slightly higher perceived chance of a Fed rate hike in 2009 following release of the minutes, but they still anticipate no move from the Fed this year.

Still, FOMC members expressed concerns that persistently high headline inflation could unmoor long-run inflation expectations.

"A number of participants worried about the possibility that core inflation might fail to moderate next year unless the stance of monetary policy was tightened sooner than currently anticipated by financial markets," the Fed said.

But with banks reluctant to lend, some analysts said low interest rates were not currently fanning inflation.

"Inflation is probably not that big of a problem this go-around because you don't have the wage-price spiral. You're not seeing growth in wages. That's the bottom line," said Carl Kaufman, fixed income portfolio manager at Osterweis Capital Management in San Francisco.

Dallas Fed President Richard Fisher was the lone dissenter in the 10-1 vote to hold rates steady. He preferred to raise rates to combat rising inflationary pressures, which he saw as a greater risk to the economy. Fisher saw businesses as being more inclined to raise prices to pass on higher costs for imported goods and other inputs, the minutes said.

In a July 24 conference call during which the FOMC and the Fed Board of Governors agreed to expand Fed lending facilities, some participants raised questions about the timing of the move, according to minutes of the call.

Some asked whether the announcement could suggest that the Fed saw markets as more fragile than expected or whether the Fed intended to keep the facilities in place permanently. But the minutes noted there was considerable support for expanding the Term Auction Facility to allow for 84-day loans to banks. (Additional reporting by Tim Ahmann; Editing by James Dalgleish)