Fed didn’t see severity of credit crunch

Federal Reserve officials put aside concerns about the rising cost of credit at their Aug. 7 meeting because they weren’t convinced that a slowdown in inflation would last, according to minutes of the meeting that were released Tuesday.

Ten days before the Fed cut its lending rate to banks, policymakers were given lower economic growth forecasts by staff economists, and noted that “strains in financial markets” jeopardized the expansion. Further turmoil might require a response, the panel acknowledged, but that sentiment didn’t appear in the statement after the meeting.

“Policymakers would need to watch the situation carefully,” the minutes said. “For the present, however, given expectations that the most likely outcome for the economy was continued moderate growth, the upside risks to inflation remained the most significant policy concern.”

On Aug. 17, the committee reversed course and lowered the so-called discount rate at which the Fed lends to banks, saying that risks to economic growth had “increased appreciably.” The Fed’s main short-term interest rate, however, has remained at 5.25%.

Policymakers underestimated the contagion from sub-prime credit markets to less risky borrowers, the minutes showed.

“Funding had become more costly and difficult to obtain for riskier corporate borrowers, but there had been little net change in the cost of credit for investment-grade businesses,” the minutes said.

“The mistake the Fed made is that the market was clearly coming unglued prior to the meeting,” said Scott Minerd, who helps oversees $24 billion of stocks and bonds at Guggenheim Partners in Santa Monica. By maintaining the inflation bias, “it telegraphed to the market that this Fed was really out of touch with how severe the credit dislocation was.”