Some FOMC Members Saw Risk of "Prolonged and Severe" Downturn, Minutes Show

Minutes from the Federal Open Market Committee's March 18 meeting revealed several members saw a risk of a "prolonged and severe" downturn and that there had been "little indication" of stabilization in the U.S. housing market.

Officials had concerns that price expectations might loosen and had discussed evidence of an "adverse feedback loop," the minutes showed.

It was also revealed that some members raised concerns about a precedent being sent on March 10 in regards to the Terms Securities Lending Facility (TSLF) operation and that the Fed recognizes rate policy alone can't solve the market problems.

On March 18, the FOMC cut the target for the Fed funds rate by 75 bps to 2.25%, short of forecasts for a 100bp cut. Richard Fisher of the Dallas Fed and Charles Plosser of the Philadelphia Fed both dissented, favouring "less aggressive action at this meeting." Both members are reputed hawks.

Fed officials had seen that the economic outlook had "weakened considerably" and that Fed staff "substantially" cut the GDP forecast.

"The outlook for economic activity had weakened considerably since the January meeting, and members viewed the downside risks to economic growth as having increased," the minutes read. "Indeed, some believed that a prolonged and severe economic downturn could not be ruled out given the further restriction of credit availability and ongoing weakness in the housing market."

The minutes show the some Fed officials judged recent inflation data as "disappointing", but that they see inflation moderating later in 2008 or in early 2009.

"Even with a substantial easing at this meeting, most members saw overall inflation as likely to moderate in coming quarters, reflecting a projected leveling-out of energy and commodity prices and an easing of pressures on resource utilization," the minutes also said. "However, inflation pressures had apparently risen even as the outlook for growth had weakened."

RBC Capital Markets fixed income strategist TJ Marta said the minutes reflect increasing concerns that "stagflation-lite" could develop. "This would not be the stagflation of the '70's (double-digit inflation and very negative growth), but would rather be core inflation entrenched above 2% with prolonged, sub-trend growth," he wrote in a client note following the release of the minutes.

On March 18, the FOMC statement highlighted a further weakening of economic activity characterized by a slowdown in consumer spending and a softer labour market, as well as elevated inflation. The markets took the Fed's show of strength combined with the setting up of further lending facilities aimed at providing additional liquidity to tighter credit markets as a sign that the central bank was in control of the situation.

Prior to the release of the FOMC minutes, markets were pricing in a 40% chance of a 50bp cut at the upcoming meeting scheduled for April 30. Expectations rose slightly to 44% following the release.

Futures on the U.S. two-year note surged to session highs following the release of minutes from the March 18 FOMC meeting which showed many Federal Reserve officials believe a decline in GDP is "likely". The immediate reaction was felt most at the front end of the curve, where two-year note climbed to 107-01 from 106-30. The yield on the spot market fell from 1.87% to 1.84%, marking a session low.

U.S. equity markets also frowned at the minutes, with the S&P 500 falling 10 point to a session low of 1362.

By Stephen Huebl and edited by Nancy Girgis