Fed saw risks to economy despite low rates: minutes

By Mark Felsenthal

WASHINGTON (Reuters) - Federal Reserve officials believed the U.S. economy would face "substantial" risks even as benchmark interest rates were cut to near zero, with some worrying about the risk of deflation, minutes of a December rate-setting meeting released on Tuesday showed.

At the December 15-16 meeting, the U.S. central bank chopped overnight borrowing costs to a range of between zero and 0.25 percent, and with rates pushed to the floor, signaled it was ready to try to lift the economy by pumping vast amounts of money into distressed financial markets.

"Even with the additional use of nontraditional policies, the economic outlook would remain weak for a time and the downside risks to economic activity would be substantial," the Fed minutes said.

Fed officials took note of the crumbling jobs market and flagging output and concluded the economy would contract sharply in the last three months of 2008 and in early 2009. Some worried about an even more prolonged contraction.

Fed staff revised down sharply their outlook for economic activity in 2009 but projected a moderate recovery in 2010, the report showed. U.S. growth was expected to fall much more sharply in early 2009 than previously anticipated and decline for the year as a whole.

"These minutes are a shock to the senses -- a stark reminder of the current weak environment we''re in," said Brian Dolan, chief currency strategist at FOREX.com, in Bedminster, New Jersey.

Wall Street stock markets rallied and the U.S. dollar pared gains against the euro after the minutes were released as investors bet on further aggressive government actions to stimulate the recession-mired economy. The blue-chip Dow Jones industrial average .DJI closed up 0.69 percent.

ENTERING A NEW ERA

In announcing their decision to cut interest rates on December 16, the Fed said it expected weak economic conditions to warrant unusually low rates "for some time."

The minutes showed that policy-makers wanted to send a clear message that they intended to keep interest rates very low for an extended period to stimulate the economy and prevent a damaging deflationary spiral.

"Participants judged that communicating the committee''s expectation that short-term interest rates were likely to stay exceptionally low for some time could be useful," the report said. Expectations of low short-term interest rates can help lower the longer-term rates set in financial markets.

The U.S. economy slid into recession in December 2007 in the wake of the collapse of the U.S. housing market and a severe credit crunch that has hammered growth rates worldwide.

U.S. unemployment hit a 15-year high of 6.7 percent in November, and a report on Friday is expected to show it climbed to 7 percent last month.

With interest rates at or near zero, Fed officials discussed how else they could breathe life into the economy and prevent sustained deflation, a broad decline in prices that could further sap activity by causing consumers to delay purchases.

They revived consideration of setting more explicit goals for inflation, a step some officials believe could help in a deflation fight.  Continued...