Policymakers at the
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,
( BSC), 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
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."
Under those circumstances, Fed officials concluded that the U.S. financial system was unusually fragile.
"Evidence that an adverse feedback loop was under way, in which a restriction in credit availability prompts a deterioration in the economic outlook that, in turn, spurs additional tightening in credit conditions, was discussed," said the minutes from the March meeting. "Several participants noted that the problems of declining asset values, credit losses, and strained financial market conditions could be quite persistent, restraining credit availability and thus economic activity for a time and having the potential subsequently to delay and damp economic recovery."
The main source of uncertainty in the markets stemmed from persistent declines in home prices, and Fed officials noted that the evidence available suggested that the downward trend in housing prices looked poised to continue.
"Elevated rates of foreclosures and large inventories of unsold property were likely to depress home prices for some time," said the minutes. "Lower home prices would eventually buoy home buying, but in the meantime the prospect of continued price declines could lead potential homebuyers to defer purchases for a time, further damping housing activity and adding to downward pressure on home values."
In addition to that possibility, inflation remains a concern. Charles Plosser, president of the Federal Reserve Bank of Philadelphia, and Richard Fisher, president of the Federal Reserve Bank of Dallas, both voted to abstain from the Fed's March decision to lower rates by 75 basis points. They preferred a smaller rate cut due to concerns that expectations for inflation in the U.S. economy will become "unhinged" as the dollar drops in value while commodity prices rise.
"Mr. Fisher stressed the international influences on U.S. inflation rates," said the minutes. "Mr. Plosser noted that the committee could not afford to wait until there was clear evidence that inflation expectations were no longer anchored, as by then it would be too late to prevent a further increase in inflation pressures."
Stocks were trading lower after the release of the Fed minutes. The
Dow Jones Industrial Average
closed down 0.3%, while the
sank 0.7% and the Nasdaq Composite was off 0.5%. Shares of
closed down more than 10%, while
was down 3.4% and
( LEH) was down 2.1%.
Joseph LaVorgna, chief U.S. economist with Deutsche Bank, said the market is now expecting rate cuts from the Fed to slow, but he raised the possibility that the central bank could wind up buying mortgage debt outright from financial institutions to restore confidence.
"There are more rate cuts to come, but I wouldn't rule out more extraordinary measures from the Fed," said LaVorgna.