Credit turmoil has raised risks to economy: Fed

ATLANTA (Reuters) - Recent credit market turmoil has increased downside risks for the economy, but the U.S. Federal Reserve would refrain from taking action to bail out investors who made bad decisions, top policy-makers said on Thursday.

“The balance of risk to the economy seems to have shifted,” said Atlanta Federal Reserve Bank president Charles Lockhart. “We’re facing greater uncertainty in the economic outlook.”

Concern that problems in the U.S. subprime market have impacted the wider availability of credit has roiled financial markets around the world since they surfaced last month.

Worry that credit markets might seize up forced the Fed to lower its discount rate, its key bank lending rate, by a half percentage point on August 17 and acknowledge the turmoil might restrain growth.

“I think the probability of recession is higher than it used to be,” St. Louis Federal Reserve Bank President William Poole said in London, adding that the Fed was monitoring conditions closely in the U.S. economy but that he didn’t foresee a nosedive in activity.

Financial markets have been clamoring for the Fed to cut its benchmark lending rate at its next rate-setting meeting on September 18.

But Fed policy-makers were clear to state that the central bank was not in the business to bail out investors who took risks.

Speaking in New Mexico, Dallas Federal Reserve Bank President Richard Fisher put it bluntly: “The job of the Federal Reserve is not to bail out risk-takers: You’re a big boy, you take risks, you bear the consequences.”

Policy-makers also said that the slumping housing market and mortgage problems had yet to clearly impact economic growth.

Aside from the housing sector, “the rest of the economy continues to do reasonably well,” Kansas City Federal Reserve Bank President Thomas Hoenig said in an interview on Public Broadcasting Service’s Nightly Business Report.

Poole and Hoenig are voting members this year on the Federal Open Market Committee. Fisher will be a voting member in 2008.

Separately, Fed Governor Randall Kroszner told a conference: “We continue to follow these developments in financial markets closely, particularly those that may have a broad impact on real economic activity.”

MARKETS AND THE ECONOMY

“The Fed is really focusing on two issues: the working of the credit markets and the economy,” said William Sullivan, chief economist JVB Financial Group. “The economy seems to be holding its own.”

But he added, “when you look at the credit market situation there are huge stresses” that could lead to a rate cut. The financial market upheavals are important for the Fed to watch because “if credit market stresses are sustained, eventually the economy will suffer.”

Markets overall took the remarks, as well as some brighter economic data on Thursday, to scale back their expectations for a deep rate cut at the September FOMC meeting.

Rate futures indicated prospects for a 50 basis point in September falling to 38 percent from 72 percent. That was the lowest point since August 28 based on closing values.

But tensions in credit markets prompted central banks to pump ample liquidity into the banking system on Thursday.

The Fed injected $31.25 billion in temporary reserves to the banking system via system repurchase agreements while earlier the European Central Bank added 42.245 billion euros ($57.4 billion) in temporary overnight funds to ease tension in the euro interbank lending market.

Separate data showed major banks borrowed an average of $1.34 billion per day from the Federal Reserve in the latest week, less than during the previous week but still well above recent averages in a possible sign that the central bank’s effort to remove the discount window’s stigma may be working.

Earlier in the day, the ECB and the Bank of England left interest rates steady. Prior to the current market upheaval, both banks had been expected to raise rates in the near future to stem inflation.