Fed Minutes Confirm Gloomy Outlook

Policymakers at the Federal Reserve acknowledged the potential for a deep downturn amid mounting inflation as central bankers discussed the bleak economic conditions in the U.S. in March, according to minutes from the central bank's latest meeting released Tuesday.

Fed officials stuck to their forecast that while some contraction in the U.S. "now appeared likely" in the first half of 2008, they expected the economy to begin to improve in the second half of the year, according to the minutes of the March 18 meeting. Officials expect the recovery to be followed by a stabilization in the national housing market that will "foster a further pickup" in the economy in 2009.

That said, central bankers also noted that "considerable uncertainty" surrounded the forecast.

The minutes of the meeting said "some participants expressed concern that falling house prices and stresses in financial markets could lead to a more severe and protracted downturn in activity than currently anticipated."

They added, "participants noted that recent readings on inflation had generally been elevated, that energy prices had risen sharply, and that some indicators of inflation expectations had risen."

The Fed's March 18 meeting was held after a weekend of extraordinary events in the history of Wall Street and the U.S. central bank. On the previous Thursday, Bear Stearns (BSC Quote), the fifth largest U.S. investment bank, notified the Fed that its liquidity position was eroding and it was on the verge of bankruptcy.

In response, the Fed backstopped nearly $30 billion of Bear's riskiest mortgage-related securities to orchestrate a swift acquisition of the bank by JPMorgan Chase(JPM Quote) for a stunning $2 a share, a controversial price that was later renegotiated up to $10 a share.

"Normally, the market sorts out which companies survive and which fail, and that is as it should be," said Bernanke in recent Congressional testimony. "However, the issues raised here extended well beyond the fate of one company."

The Fed has justified its extraordinary actions on behalf of Bear Stearns as a measure aimed at preventing a systemic collapse in the U.S. financial system that the firm's bankruptcy could have trigged. Furthermore, the central bank agreed to let other investment banks borrow directly from it on similar terms as banks, marking the broadest expansion of the Fed's powers since the Great Depression.

While regulators and investors have strained to come to terms with the expansion of the Fed's role in financial system, the central bank has also slashed its key target for short-term interest rates by 200 basis points this year, leaving the current target at 2.25%-- a full three percentage points below its level last summer.

Expectations in the market suggest the Fed is likely to lower rates by another 50 basis points later this month. While the central bankers were largely confident that their actions will stabilize the economy and financial markets later this year, some doubt remains that they will ultimately be successful.

Officials at the March meeting noted that the economy had showed broad signs of slowing since the Fed's January meeting, with business spending and consumer spending showing signs of weakness amid the largest price drops in the U.S. residential real estate market on record since the Great Depression.

Moreover, "stresses in the financial markets" had also "intensified" since January.

"Several meeting participants noted that price discovery for mortgage-related financial assets had become increasingly difficult in an environment of declining house prices and considerable uncertainty as to the ultimate extent of such declines," said the minutes. "With the magnitude and distribution of losses on mortgage assets quite unclear and many financial institutions experiencing significant balance sheet pressures, many lenders pulled back from risk taking -- notably by increasing collateral margins on secured lending -- and liquidity diminished in a number of financial markets."