Fed worried about credit crunch

Federal Reserve officials worried last month that a credit crunch could sharply brake economic growth and require a further sharp reduction in interest rates, according to minutes of the Fed’s Dec. 11 policy meeting released Wednesday.

“Some members noted the risk of an unfavorable feedback loop in which credit market conditions restrained economic growth further, leading to additional tightening of credit; such an adverse development could require a substantial further easing of policy,” the central bank said in the minutes.

At the same time, members of the rate-setting Federal Open Market Committee said financial market conditions might improve more rapidly than they expected, which would make it appropriate to raise borrowing costs, reversing earlier cuts.

At the meeting last month, the Fed cut its key interest rate by a quarter of a percentage point to 4.25%. Boston Fed President Eric Rosengren dissented, preferring a more aggressive reduction.

Risks to growth had risen since the committee’s previous meeting in October, largely because of deteriorating credit markets, the minutes say.

Even so, the panel members weighed the effect of cumulative interest rate cuts and a strong labor market, which suggested that the economy retained some forward momentum.

“Although members agreed that the stance of policy should be eased, they also recognized that the situation was quite fluid and the economic outlook unusually uncertain,” the minutes said.

The minutes show a growing concern at the Fed that signs of economic softening, coupled with credit market strains, posed a risk to the economy.

The Fed’s staff had lowered its estimate for growth in the final months of 2007 and had projected the economy to expand at a rate “noticeably below its potential” in 2008.

“Growth in late 2007 and during 2008 was likely to be somewhat more sluggish” than expected in October, the minutes say.

The Dec. 11 quarter-point cut in the Fed’s target for the benchmark federal funds rate, which banks charge each other for overnight loans, disappointed many investors on Wall Street, who had expected a half-point cut.

The Fed also trimmed its discount rate, which it charges banks for direct loans, by a quarter-point the same day. That reduction also was smaller than hoped for by many investors.

The next day, however, the Fed and central banks around the world banded together to announce a series of steps to ease credit market strains.

As part of that effort, the Fed lent $40 billion to banks through two auctions last month and is set to hold two more such auctions this month. The central bank has said it will continue the auctions if necessary to break logjams in credit markets.