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Fed's Not Forgetting Inflation

The central bank recognized the strains in the credit markets Aug. 7, but it didn't see a need to cut rates.
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Federal Reserve

officials appeared to still be more concerned about inflation than the potential for a meltdown in the credit world at their Aug. 7 meeting, but they did think they might have to take steps to calm the situation, according to the minutes of the gathering.

The credit turmoil, spurred by the discombobulation in the mortgage market, worsened afterward, and 10 days following the policy conference the Fed lowered the discount rate.

The Fed didn't mention a rate cut specifically in the minutes, released Tuesday, but it did provide hints that such a move was being considered at the time.

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A further deterioration in financial conditions could not be ruled out and, to the extent such a development could have an adverse effect on growth prospects, might require a policy response. Policymakers would need to watch the situation carefully," the minutes said.

On Aug. 17, the discount rate was reduced by 50 basis points to 5.75%. The discount rate is the interest banks are charged for borrowing from the Fed.

However, at the meeting, the bankers reiterated many of their long-held fears that the economy could advance too fast.

The Fed said that "economic activity picked up in the second quarter from the slow pace in the first quarter. On average, the economy expanded at a moderate pace during the first half of the year despite the ongoing drag from the housing sector."

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While the pace of consumer spending declined in the quarter, "wages and salaries increased solidly and household sentiment appeared supportive of further gains in spending," the Fed said.

Overall inflation did pull back in June thanks to a drop in energy prices, and the core personal consumption expenditure price index, closely watched by the Fed, climbed a little less than its average for the past year.

Regarding the economic situation and outlook, the participants at the meeting said they continued to view "moderate economic expansion in coming quarters" as the most likely outcome "but that the downside risks to growth had increased." Inflation should slow going forward, they said.

Even so, the central bankers worried that high levels of resource utilization and slower productivity growth "could augment inflation pressures. Against this backdrop, the

Federal Open Market Committee agreed that the risk that inflation would fail to moderate as expected remained its predominant policy concern."

The FOMC, the Fed's policymaking arm, left the fed funds target rate at 5.25%, where it has been since June 2006. The fed funds rate is what banks charge each other for overnight loans.

Fed members did express concern that the housing slowdown would continue to hinder growth, representing a significant risk to the economy. The strains in the financial markets were also a threat, the Fed said.

Though the Fed is expecting more normal conditions to return, the process could take some time, particularly in the subprime mortgage space. The group will meet again Sept. 18, and many traders and analysts are expecting a reduction in the fed funds target rate then or even before.

The minutes noted that demand for housing in the second quarter was held down by higher interest rates and tightening credit conditions in the subprime market. Sales of new and existing homes in the quarter fell substantially from their average levels in the back half of last year.

House-price appreciation continued to slow, with some measures again showing declines in home values, the minutes said. Nonresidential construction outlays rose rapidly.