The Federal Reserve’s decision to slash short-term interest rates at the end of October was driven by a belief that inflation will edge down in coming years, and that unexpected economic weakness could cause a further tightening of credit markets.
Minutes of the Oct. 30-31 meeting of the Fed’s Open Market Committee also show the decision to slash the federal funds rate and discount rate by 25 basis points was a close one.
In the end, concerns about disruption in financial markets that’s restricted lending outweighed worries that reducing short-term interest rates would devalue the dollar and increase the risk of inflation.
The move left the target rate for the federal funds rate at 4.5 percent and the discount rate at 5 percent. The federal funds rate is the rate banks charge each other for overnight loans, while the discount rate is the rate the Fed charges for direct loans to banks.
Last week, Federal Reserve Gov. Randall Kroszner said those numbers could reflect a neutral position where the downside risk to economic growth is roughly balanced by the upside risk to inflation (see Inman News story).
In October, members of the committee believed that conditions in corporate credit markets had improved in the weeks leading up to the meeting. Most businesses “were apparently having little difficulty raising external funds, as evidenced by strong issuance of investment-grade corporate bonds, a pickup in speculative-grade issuance, and surging (commercial and industrial) loans,” the minutes said.
The markets for nonconforming mortgages, by contrast, “remained disrupted.” While financial market conditions had improved, “unusual pressures in funding markets persisted. Participants generally viewed financial markets as still fragile and were concerned that an adverse shock — such as a sharp deterioration in credit quality or disclosure of unusually large and unanticipated losses — could further dent investor confidence and significantly increase the downside risks to the economy.”
Members of the committee pointed to the deterioration in nonprime mortgage markets — and higher interest rates and tighter credit standards for prime nonconforming mortgages — as factors that exacerbating the deterioration in housing markets.
These developments “could further limit the availability of mortgage credit and depress the demand for housing,” while the large volume of interest-rate resets on subprime mortgages in coming quarters could lead to a faster pace of foreclosures and intensify the downward pressure on house prices, some members feared.
According to a summary of economic projections made by Federal Reserve Board members and Reserve Bank presidents included as an addendum to the minutes, data on economic growth outside the United States indicated that the global expansion, “though likely to slow somewhat in coming quarters, was nevertheless on a firm footing.”
The continued strength of global growth and the recent decline in the foreign exchange value of the dollar were seen as likely to support U.S. exports going forward.
Projections for real GDP growth in 2008 were revised down to 1.8 percent to 2.5 percent, compared with 2.25 to 2.75 percent in June. The revisions to the 2008 outlook were attributed to tightened terms and reduced availability of subprime and jumbo mortgages, weaker-than-expected housing data and rising oil prices.
Declining housing wealth was expected to increase the personal saving rate over the next few years, contributing to restraint on the growth of personal consumption expenditures.