Fed Officials Saw Contraction in Economy `Likely' (Update4)

By Craig Torres


April 8 (Bloomberg) -- Federal Reserve officials anticipated that the economy would shrink in the first half of the year, with some concerned about ``a prolonged and severe economic downturn.''

``Many participants thought some contraction in economic activity in the first half of 2008 now appeared likely,'' the Fed said in minutes of the March 18 Federal Open Market Committee meeting released in Washington today.

Policy makers also found little sign that housing markets have reached a bottom, the minutes showed. Traders increased bets that the Fed will lower its benchmark interest rate half a point when policy makers meet April 29-30, futures prices show.

``Some believed that a prolonged and severe economic downturn could not be ruled out,'' the Fed minutes said, referring to FOMC meeting participants.

The minutes encompass a period when Chairman Ben S. Bernanke invoked rarely used authority to provide emergency financing for investment banks and rescued Bear Stearns Cos. from bankruptcy. Officials are seeking to limit the impact on the broader economy of what former Fed chief Alan Greenspan today termed the worst credit crisis in 50 years.

The Bear Stearns financing took the Fed ``to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles,'' Paul Volcker, chairman of the Fed from 1979 to 1987, told the Economic Club of New York today.

Futures Trading

Odds of a half-point rate cut, to 1.75 percent, rose to 46 percent today from 36 percent yesterday, futures showed. There's a 100 percent chance of at least a quarter-point reduction, the contracts indicate.

Policy makers lowered the rate three-quarters of a point at the March meeting, for a total of 2 percentage points so far this year, the fastest drop in borrowing costs in two decades.

``Members recognized that monetary policy alone could not address fully the underlying problems in the housing market and financial markets,'' the minutes said today.

Detailed Fed Board discussions of the $29 billion loan against Bear Stearns securities weren't included in the minutes because the full FOMC didn't participate in the decision.

Today's report does describe a March 10 conference call, when Fed officials decided to increase swap lines with the Swiss National Bank and the European Central Bank and establish a securities lending facility for government bond dealers.

`Turning Point'

The Fed's March actions are ``definitely a major turning point in our understanding of the role of the lender-of-last- resort in modern markets,'' Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, said before the release.

Fed staff economists told policy makers they had ``substantially revised down'' their forecast to show a first- half contraction in gross domestic product, with a ``slow rise'' in the second half. In 2009, the staff projected growth ``somewhat above'' the economy's long-term potential pace, the minutes showed.

The staff's first-half forecast compares with Bernanke's April 2 assessment that ``we are slightly growing at the moment, but we think that there's a chance that, for the first half as a whole, there might be a slight contraction.''

Committee members discussed evidence of an ``adverse feedback loop,'' where lenders reduce credit, hurting growth and causing lending to contract further, the minutes showed.

Credit Impact

``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,'' the minutes said.

Anecdotal reports ``pointed to a retrenchment in capital spending,'' the minutes said.

The Fed took three steps in March to help offset money market constraints.

On March 7, the Fed announced that it would expand its auctions of funds to commercial banks to $100 billion a month, from $60 billion. The board also announced up to $100 billion in term repurchase agreements.

On March 10, the FOMC voted in favor of swapping up to $200 billion of Treasuries out of its portfolio in exchange for primary dealers' holdings of mortgage securities. Policy makers ``expressed concerns'' during their call, saying the program ``could be viewed as setting a precedent and thus raise expectations of other actions in the future,'' the minutes said.

Bear Help

On Sunday, March 16, the Fed Board also reduced the premium on direct loans to banks over the benchmark overnight rate, to a quarter point from half a point. The Board also approved financing $30 billion of illiquid Bear Stearns assets to help facilitate the merger with JPMorgan Chase & Co.

To stave off a run against large investment banks, the Fed Board also voted unanimously in favor of opening a discount window for primary government bond dealers.

The number of Americans signing contracts to buy previously owned homes declined more than forecast in February, a report showed today, indicating no sign of a bottom in the U.S. real- estate recession that is entering its third year.

Foreclosures rose to 0.83 percent of all home loans in the final quarter of last year, an all-time high, according to the Mortgage Bankers Association.

Policy makers saw ``little indication'' that the stabilization in housing markets had begun, the minutes said. ``Participants noted that the trajectory of house prices was a major source of uncertainty in their economic outlook.''

The Fed's preferred inflation measure, the personal consumption expenditures price index minus food and energy, rose 2 percent for the 12-month period ending February. Fed officials said ``recent information on inflation was disappointing,'' the minutes said, although weaker growth should reduce price pressures over time, some members said. Fed staff economists projected inflation would slow next year.