Fed driven by danger of worsening recession

/ Source: The Associated Press

The Federal Reserve’s decision last month to plow $1.2 trillion into the economy reflected growing concerns about a vicious economic cycle in which rising unemployment will curtail consumer spending, potentially into 2010.

Documents released Wednesday provided insights into the Fed’s decision to revive the economy by buying long-term government debt and boosting purchases of mortgage-backed securities from Fannie Mae and Freddie Mac. Projections for economic activity in the second half of 2009 and in 2010 “were revised down” by the Fed’s staff, who did not provide updated forecasts.

“Most participants viewed downside risks as predominating in the near term,” according to minutes of the Fed’s closed-door meeting on March 17-18.

And with the economy likely to stay fragile, the unemployment rate — now at a quarter-century high of 8.5 percent — will probably “rise more steeply into early next year before flattening out at a high level over the rest of the year,” the minutes said.

The bleak outlook stems mainly from a cycle where rising joblessness prompted cutbacks by consumers, which in turn led to more layoffs and reduced production by businesses. Such forces would weaken the economy even more, triggering further credit tightening and additional losses at financial institutions, the Fed explained.

Against that backdrop, the central bank decided to hold its key lending rate at a record low of between zero and 0.25 percent. Economists predict the Fed will hold the rate in that zone for the rest of this year and for most — if not all of — next year.

In addition, Fed Chairman Ben Bernanke and his colleagues turned to other unconventional tools to revive the economy. The Fed said it would spend up to $300 billion to buy long-term government bonds and would buy an additional $750 billion in Fannie and Freddie securities.

“The Fed saw red in terms of the downgraded economic outlook and had to come up with a bold move and indeed it did,” said Richard Yamarone, economist at Argus Research.

The economy had deteriorated more than Fed policymakers expected from their previous meeting in January. Of particular concern was the sharp drop in demand overseas, which was hurting sales of U.S. exports, the Fed said. That meant exports wouldn’t likely be a source of support for economic activity in the near term.

The Fed minutes said that gross domestic product was “expected to flatten out gradually over the second half of this year and then to expand slowly next year as the stresses of the financial markets ease, the effects of fiscal stimulus take hold, inventory adjustments are worked through and the correction in housing activity comes to and end.”

GDP measures the value of all goods and services produced within the U.S. and is the broadest measure of the country’s economic health. It contracted at a 6.3 percent pace in the final quarter of last year, the worst showing in a quarter-century. Many economists expect the economy performed nearly as poorly in the first three months of this year.

The government will release its estimate of first-quarter GDP later this month. Many analysts believe the economy is shrinking in the current quarter, but probably not as much as in the fourth quarter.

Still, Fed policymakers believed that policies in place would eventually lead to an economic recovery, although an exact time table wasn’t offered. President Barack Obama’s $787 billion package of increased government spending and tax cuts, along with the administration’s bank-rescue efforts and a program to reduce home foreclosures will provide some level of relief.

However, Fed officials expressed “a variety of views about the strength and the timing of the recovery.”

Some believed the “natural resilience of market forces” would become evident later this year. Others saw a recovery as “delayed and potentially weak” because consumers would stay very cautious.

The Fed’s decision to launch the $1.2 trillion program was viewed as helping to address “the very weak economic outlook” and thwart the prospect of deflation, a dangerous bout of falling prices. The Fed spoke the need to “reduce the risk that inflation could persist for a time below rates that best foster longer-term economic growth and price stability.”

Some Fed officials talked about some challenges faced by a program, created by the Fed and the Treasury Department, aimed at jump-starting loans to consumers and small businesses.

The program — called the Term Asset-Backed Securities Loan Facility — which launched last month, has gotten off to a slow start. Some investors were worried about “potential future changes in government policies,” the minutes said.

The Fed on Tuesday said just $1.7 billion in loans were requested for the second round of funding in April. That was down from $4.7 billion requested in the first operation last month.