Fed Put Inflation Skepticism Above Credit Concern (Update4)
By Scott Lanman
Aug. 28 (Bloomberg) -- Federal Reserve officials put aside concerns about the rising cost of credit at their Aug. 7 meeting because they weren't convinced a slowdown in inflation would last, minutes of the gathering said.
Ten days before the Fed was forced to cut a key interest rate, the Federal Open Market Committee was given lower growth forecasts by staff economists, and noted that ``strains in financial markets'' jeopardized the expansion. Further turmoil might require a response, the panel acknowledged, though that sentiment didn't appear in the statement after the meeting.
``Policy makers would need to watch the situation carefully,'' the central bank 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.''
The records don't include the Aug. 16 emergency video conference when the FOMC reversed course and lowered the discount rate, saying that risks to economic growth had ``increased appreciably.'' The benchmark lending rate was kept unchanged at 5.25 percent.
Policy makers underestimated the contagion from subprime 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 Fed said.
The yield premium investors demand to buy investment-grade corporate bonds compared with benchmark Treasury securities had jumped almost a quarter of a percentage point in the two weeks before the Aug. 7 meeting. The gap widened to 1.47 percentage points on Aug. 21, the highest in four years, Merrill Lynch & Co. data show.
``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 LLC in Santa Monica, California. 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.''
Stocks extended declines after the report. The Standard & Poor's 500 index closed down 2.4 percent at 1,432.36 in New York.
Chairman Ben S. Bernanke may offer insight on the Fed's current assessment of the economic outlook when he speaks on Aug. 31. Bernanke will address the Kansas City Fed's annual symposium in Jackson Hole, Wyoming, traditionally attended by most Fed governors and district-bank presidents.
As of three weeks ago, policy makers ``expected a return to more normal market conditions, but recognized that the process likely would take some time,'' the minutes showed. They noted that ``mortgage loans remained readily available to most potential borrowers,'' and the ``supply of credit to finance real investment did not appear significantly diminished.''
Traders and economists expect the Fed to lower its benchmark rate at or before the next meeting, on Sept. 18, according to futures traded on the Chicago Board of Trade.
As policy makers gathered three weeks ago, reports showed inflation had slowed while economic growth had accelerated in the second quarter. Gross domestic product rose at a 3.4 percent annual pace in April to June, the fastest in more than a year.
On inflation, ``meeting participants believed that the readings for the past few months likely had been damped by transitory factors and did not provide reliable evidence that the recent level would be sustained,'' the minutes said.
Officials kept the target rate for overnight loans between banks, the main policy tool, at 5.25 percent for a ninth straight meeting. While the Fed conceded that ``downside risks to growth have increased somewhat,'' citing tumult in financial markets, officials reiterated in the Aug. 7 statement that inflation was the ``predominant'' policy concern.
That disappointed some investors and observers, who argued a balanced assessment was warranted by increasing signs of stress in financial markets, sparked by an exodus from securities backed by subprime mortgages.
The S&P 500 Index fell 5.7 percent from its record high on July 16 through Aug. 6. The premium on investment-grade corporate bond yields compared with benchmark Treasuries on July 25 jumped the most in five years, data from Merrill Lynch & Co. showed. Sam Molinaro, the chief financial officer of Bear Stearns Cos., where two hedge funds failed in June, said Aug. 3 that the fixed-income market was in the worst shape in 22 years.
Fed officials ``still saw moderate economic expansion in coming quarters as the most likely outcome but that the downside risks to growth had increased,'' according to the Aug. 7 minutes.
Fed staff economists said the U.S. economy would grow at a ``somewhat'' slower pace in the second half of 2007 and in 2008 than previously anticipated. They cited figures released July 27 showing the economy expanded an average 3.2 percent from 2004 through 2006, revised down from 3.5 percent. That prompted the staff to judge the economy's speed limit had fallen.
Three days after officials met, the Fed pumped $38 billion into the banking system -- the most since the 2001 terrorist attacks -- in its first effort to contain the credit crunch. The effort failed to quell the upheaval, as the amount outstanding of commercial paper, a key short-term financing tool for some finance companies, slid the most in six years.
The following week, with borrowing continuing to dry up, the Fed took steps unprecedented in recent years: it cut the rate on direct loans to banks and issued a new outlook that recognized economic risks had risen ``appreciably'' and omitted any mention of inflation.
Minutes of the FOMC's Aug. 16 videoconference will be included in records of the Sept. 18 meeting, to be released Oct. 9. The Board of Governors' separate decision to cut the discount- lending rate to 5.75 percent from 6.25 percent will be detailed in another report, around Oct. 16.