Fed cut rates to limit damage from credit turmoil

WASHINGTON (Reuters) - Concern that a credit crunch and financial market disarray could hit the U.S. economy prompted the Federal Reserve to cut interest rates sharply last month, even though it was unclear how serious any damage could be.

All members of the Fed's rate-setting panel agreed a hefty half-percentage point reduction in benchmark rates to 4.75 percent was the best course to limit potential harm, according to minutes of their September 18 meeting released on Tuesday that showed no discussion of the smaller quarter-point move markets had expected.

"In order to help forestall some of the adverse effects on the economy that might otherwise arise, all members agreed that a rate cut of 50 basis points at this meeting was the most prudent course of action," minutes of their September 18 meeting said.

Members of the U.S. central bank's policy-setting Federal Open Market Committee felt well positioned to trim rates because the inflation fears that had dominated policy concerns in prior meetings had receded.

"The inflation situation seemed to have improved slightly," the Fed said. "It was no longer appropriate to indicate that a sustained moderation in inflation pressures had yet to be shown."

Even as policy-makers found incoming data of little value in interpreting the rapidly evolving situation, they believed a rate cut would offset the effects of financial market turmoil without risking a rekindling of price pressures.

"With economic growth likely to run below its potential for a while and with incoming inflation data to the favorable side, the easing of policy seemed unlikely to affect adversely the outlook for inflation," the Fed said.

Markets took mixed messages from the minutes. Stock markets rose as investors read the Fed's diminished anxiety about price pressures as a signal further rate cuts are in the cards.

But U.S. Treasuries slipped as traders saw the potential for the Fed to hold steady as financial markets stabilize.

"Officials were most concerned with the conditions in the credit markets at the time of the rate cut," said Owen Esiner, a foreign exchange analyst at Ruesch International in Washington. "If the main reason for the rate cut back in September was to help normalize credit conditions, we have seen that come to fruition, somewhat."

The Fed felt sufficiently uncertain about how events would unfold that it dropped language about the balance of risks to the economy because it did not want to give markets the impression it was confident about the future path for growth or inflation.

"The committee decided to refrain from providing an explicit assessment of the balance of risks, as such a characterization could give the mistaken impression that the committee was more certain about the economic outlook than was in fact the case," the Fed said.

Policy-makers worried that tightening credit conditions and the deepening housing slump that had been triggered by a spike in mortgage foreclosures could lead to "significant weakness" in business activity and hiring.

Also, the damage to financial markets as credit dried up could get worse and further chill economic activity, monetary policy-makers thought.

The minutes show Fed officials uncertain about whether the credit crunch would substantially slow economic growth or not.

They believed risks were tilted toward a slowdown in economic activity, but also noted that the economy had previously weathered periods of financial disruption with only limited broadly adverse effects.

Fed officials believed that tighter credit would restrain economic growth in the period ahead, and worried that any further disruptions in financial markets could magnify risks to the economy.

The Fed went as far as discussing "additional policy options" to address strains in money markets at the meeting, but no decisions were made at the time, the minutes said.

While encouraged by an improving picture on inflation, policy-makers remained troubled by some potential risks. Rising labor costs, a relatively tight job market, and the weakening dollar could all contribute to inflationary pressures, the Fed said.