WASHINGTON (Dow Jones)--Days before cutting the discount rate on Aug. 17, U.S. Federal Reserve officials were worried enough about eroding financial conditions to weigh the possibility of taking policy action, according to the minutes of the Federal Open Market Committee's Aug. 7 meeting released Tuesday.
"A further deterioration in financial conditions could not be ruled out," the Fed said in the meeting minutes, released with the usual three-week lag, and such a development "might require a policy response" if it affects economic growth. Officials pledged to monitor markets "carefully."
Still, with the full extent of market fragility not known when officials met three weeks ago, the Fed still thought that inflation remained the "predominant" concern, even though they acknowledged that a "deeper and more prolonged" housing downturn was possible.
The Fed voted unanimously at its Aug. 7 meeting to keep the federal funds rate unchanged at 5.25% for a ninth-straight time dating back to last summer. It also maintained an anti-inflation bias, though officials inched closer to a neutral stance by acknowledging in the policy statement that downside growth risks had "increased somewhat."
The Fed's leaning toward inflation as the bigger risk seemed supported by economic data through July. The economy expanded at a 3.4% clip in the second quarter, and that is likely to be revised up towards 4% later this week. July data suggest the third quarter started on a solid footing as well.
Consumer spending should grow at a "moderate" pace while business investment "would be supported by solid fundamentals, the Fed said in the August minutes. Rapid overseas growth should also support growth, despite the housing drag, the Fed said.
Of course, that was then.
Ten days after that meeting, officials in a rare intermeeting move lowered the discount rate by a half percentage point, to 5.75%, to boost liquidity in short-term credit markets, which had seized up. It didn't lower the federal funds rate, which has a much broader impact on borrowing costs.
In an accompanying policy statement on Aug. 17, the Fed warned that economic risks had risen "appreciably" and made no reference to inflation, causing many Fed watchers to infer that officials now have an easing bias.
"There was a time prior to the discount-rate cut that people in the markets thought (Fed officials) were asleep at the switch," said Stephen Stanley, chief economist at RBS Greenwich Capital Markets. "These minutes show that wasn't the case," he said.
Still, the Fed clearly misread the extent of the brewing credit crisis, saying in the Aug. 7 minutes that "members expected a return to more normal market conditions," though that process would take time. Thus, "there is a bit of a head-in-the-sand feeling to the minutes," said Miller Tabak strategist Tony Crescenzi, in a research note.
The minutes from the Fed's Aug. 16 conference call that preceded the discount-rate cut will be released in early October, along with the minutes of the Fed's Sept. 18 meeting.
Still, the Fed's views on Aug. 7 matter for the rate outlook. To the extent officials were close to shifting to a neutral stance even before the credit crisis, it would support the rate-cut scenario priced into financial markets. If inflation were still a major concern, then the Fed would be more likely to keep rates steady assuming conditions in markets and, more importantly, the economic outlook don't erode.
Investors appeared to draw little if any forward-looking guidance from the minutes, and Wall Street's attention now shifts to a speech from Fed Chairman Ben Bernanke on Friday at the Kansas City Fed's annual Jackson Hole conference. Fed-funds futures contracts are pricing in as much as 100 basis points in fed funds rate cuts by year's end, starting with a 25-basis-point reduction at the Fed's next policy meeting on Sept. 18. Those bets remained in place even after investors digested the Aug. 7 meeting minutes.
The Aug. 7 minutes highlight a dilemma policymakers still face. The Fed recognized three weeks ago that tighter financial conditions would affect the economy, and cited this as a factor in the staff's reduction of its second-half 2007 and 2008 gross domestic product growth forecasts.
Recent benchmark revisions to previous GDP data were another factor, as were "the softer tone of some near-term indicators," according to the minutes. Housing, meanwhile, remains a "significant downside risk" to the economy, the Fed said.
Yet Fed staff also cut its estimates for structural productivity growth and potential GDP, suggesting that even if the economy slows it might not reduce inflation much more.
And though inflation data that exclude food and energy were "favorable" prior to the August Fed meeting, officials warned that some of that was due to "transitory" factors, and thus "did not provide reliable evidence that the recent level would be sustained," according to the meeting minutes.
Officials cited the lower value of the dollar, high "resource utilization" and slower productivity growth as inflation risks, which they said remained their "predominant" concern on Aug. 7.
The inflation references "may indicate a slightly higher bar for action than we had previously assumed as the concerns around inflation pressures are clearly widespread," said Lehman Brothers economist Drew Matus, in a research note.
Matus still expects a 25-basis point cut in the fed funds rate on Sept. 18. |
