My New Blog

Calling the outlook "unusually uncertain," the Federal Reserve cut its forecast for economic growth and raised the possibility that "substantial" interest rate cuts might be needed if financial conditions don't rebound.

Minutes of a Dec. 11 Fed meeting, released Wednesday, show the central bank staff now expects the economy to grow "noticeably below its potential in 2008" as high oil prices, lower incomes, a deteriorating housing market and constricted credit markets take a toll.

The Fed governors and regional bank presidents who make up the central bank's Federal Open Market Committee further point to slower consumer spending and note that credit market problems, which began with rising mortgage foreclosures, are spreading to other areas.

Credit card and auto loan delinquency rates have been rising. The commercial real estate bond market is showing "deterioration," the Fed said. "Strains in financial markets … could persist for quite some time," the Fed said, adding that the housing slump looked "deeper and more prolonged" than expected.

Some Fed officials worried about a possible negative "feedback loop" in which lenders, by tightening credit, cut growth and prompt a further reduction in lending.

"Such an adverse development could require a substantial further easing of policy," the minutes said. Fed officials also said credit markets might rally faster than expected, which could force a rate increase.

On Dec. 11, the Fed cut a key rate target a quarter-point to 4.25%. It was the third reduction since September, when the federal funds rate, what banks charge each other for overnight loans, was 5.25%. The rate is a benchmark for many business and consumer loans.

The central bank noted that the inflation outlook had worsened, because of rising oil and food prices, as well as the falling value of the dollar, which makes imports more expensive. That was underscored Wednesday when crude oil prices touched $100 a barrel. Still, Fed officials expect the inflation rate to decline in coming months.

The Fed did not spell out its next move, promising to "remain exceptionally alert" to conditions.

The Fed "is more sanguine about the inflation (outlook) than they are about the growth prospects," says Steven Wood of Insight Economics. He expects the Fed will cut rates when it meets Jan. 29-30 and continue until the fed funds rate is 3.5% or even lower.

The economy grew at a 4.9% annual rate in the third quarter of 2007, but fourth-quarter growth is expected to be negligible. The Fed forecasts growth of 2.5% as sustainable.