Fed minutes show argument over rate cut, inflation risks at March 18 meeting

WASHINGTON (Thomson Financial) - Minutes of the Federal Reserve's rate-setting meeting on March 18 show a deep divide between officials who feared a long and deep recession might be in the offing, and others who thought further rate cuts might let inflation free into an upward spiral.

Most members of the rate-setting Federal Open Market Committee (FOMC) thought a 'substantial easing' was warranted and voted to cut the target Fed funds rate 0.75 percentage points to 2.25 pct.

The FOMC members saw deterioration in both business and consumer spending and no sign of a stabilization in the housing market that would be needed to support future growth.

'Many participants thought some contraction in economic activity in the first half of 2008 now appeared likely,' the minutes said. That first-half contraction was also part of the Federal Reserve staff's forecast.

That forecast also projected only a temporary benefit from the fiscal stimulus package -- a boost in the second half of 2008 that disappears quickly in 2009.

IDEAglobal economist Joseph Brusuelas sees that as support for his 'W-shaped' forecast. 'Once the economy absorbs the combined stimulus from the fiscal and monetary policy implemented over the past several months, there will be little to support economic activity on over the horizon. Thus, we do think that the domestic economy is in for some very rough sledding over the remainder of the year and well into 2009,' he said.

Some people at the FOMC meeting were even more pessimistic. They thought 'that a prolonged and severe economic downturn could not be ruled out.' And they saw 'evidence that an adverse feedback loop was underway' of the precisely the kind Fed policymakers had been struggling to avoid.

In that downward spiral, a restriction in credit availability prompts a deterioration in the economic outlook that, in turn spurs additional tightening of credit.

'Not surprisingly, the minutes of the March 18 meeting portray an FOMC very concerned about the spillover effects of tightness and dysfunction in the credit markets on economic activity. Downside risks to growth were judged to be dominant, trumping any concerns about higher than desired inflation,' said MFR economist Joshua Shapiro.

The FOMC was facing a situation in which the threat to growth was paralleled with an increasing threat of inflation. Agricultural prices were 'rising at a substantial clip' and crude oil was at record levels.

One group of FOMC participants warned that their business contacts emphasized rising input costs and were trying to pass those costs on to their customers. Another group countered that the economic slowdown would put a limit on the extent of cost pass-throughs.

With both core and headline inflation remaining elevated there was concern that inflation expectations might 'become less firmly anchored' and some indicators were suggesting that expectations had 'edged higher of late.'

Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser voted against the 0.75 pct point cut, according to the minutes 'because in light of heightened inflation risks, they favored easing policy less aggressively.'

The dissenters went so far as to say that 'inflation expectations could potentially become unhinged' if the Fed continued to lower the funds rate 'in the current environment.'

It was the first time since 2002 that two FOMC voters dissented and marked the fifth consecutive meeting with a dissenting vote cast.

The March 18 meeting came just two days after the Fed agreed to provide financing through for finance JP Morgan Chase's takeover of Bear Stearns with a $30 bln loan, cut the discount rate and to open its discount window to investment companies. There was no specific discussion of that decision in the minutes.

Since the January FOMC meeting, the Fed had also opened its discount window to non-banks and established the Term Securities Lending Facility (TSLF) to lend up to $200 bln in Treasuries to investment dealers in return for less desirable collateral such as mortgage-backed securities.

The minutes of the TSLF conference call say most agreed it was an 'appropriate step,' but there was concern it would 'establish a precedent and thus raise expectations of other actions in the future.'

There was a general feeling expressed in the minutes that the Fed's various new lending facilities 'would probably be helpful in bolstering market liquidity and promoting orderly market functioning.'

Tony Crescenzi of Miller Tabak thinks the liquidity moves can matter more than the Fed funds rate now.

'What is important to investors now is not what is next for the fed funds rate, but what else the Fed might consider in response to any future events,' he said. 'Basically, with the Fed in crisis-management mode, discussions of the economy and management of the fed funds rate have been relegated to the background, with unconventional policy prescriptions at the forefront.'

Indeed, the Dallas Fed's Fisher noted in his dissent against the rate cut that a focus on liquidity measures 'would improve economic prospects more quickly and lastingly than would further reductions in the federal funds rate.'

Given the uncertainties of the economic and financial outlook, the FOMC had little trouble agreeing that 'appropriately calibrating the stance of policy was difficult.'

dennis.moore@thomson.com