By Steven K. Beckner

(MNI) - Federal Reserve policymakers were quite concerned about the sustainability of the economic recovery at their late September meeting, minutes released Wednesday show.

The Fed's policymaking Federal Open Market Committee left the overnight federal funds rate near zero on September 23, vowed to keep it "exceptionally low ... for an extended period" and voted to continue buying the full amount of previously authorized securities to hold down mortgage and other longer term rates.

The minutes show why. Despite signs of recovery, there was "considerable uncertainty" among committee members about the economy's strength once government support programs, such as the first-time homebuyer tax credit, are withdrawn or their stimulative effects wane.

Officials expected consumers and businesses to be very "cautious" about spending, and they projected unemployment will stay high "over the next few years." There was concern that the costs could be "relatively high" if the economy proved even weaker than the anticipated "moderate" pace.

In that climate, the Fed policy group saw little chance of higher inflation. Indeed some were more worried about the inflation rate falling.

While one unidentified FOMC member wanted to reduce Fed purchases of agency and agency-guaranteed mortgage backed securities, others wanted to increase them, the minutes show, and it was generally agreed that the Fed needed to have the "flexibility" to increase asset purchases if the recovery should falter.

The Fed staff gave the FOMC a report on banks' large and growing excess reserve balances at the Fed, their effect on asset prices and yields and the financial and economic impact of future reductions in reserves. The staff analysis showed that, when banks begin to scale back their holdings of reserves at the Fed in favor of increased lending, the impact on market interest rates is likely to be "gradual" and "quite limited."

Meanwhile, the minutes show there was concern about the reserve-boosting effect of the U.S. Treasury's plan to scale back its Supplementary Financing Account (SFA). Officials were worried that reserves would rise more than intended unless the Fed took offsetting steps. There was further discussion of the "continuing development" of tools to eventually shrink the Fed balance sheet.

There was no indication from the minutes, however, that a majority is contemplating doing that or raising interest rates anytime soon.

The staff was more optimistic than the Committee itself.

Minutes reveal that the Fed staff raised its forecast for real GDP growth for the second half and for 2010 for the meeting. "The staff projected that real GDP would increase in the second half of 2009 at a rate somewhat above the growth rate of potential output."

"For 2010, the staff forecast that output growth would continue to strengthen, supported by an ongoing improvement in financial conditions, a fading of the drag from earlier declines in income and wealth, accommodative monetary and fiscal policy, and recovery in the housing sector," the minutes disclose. "These factors also contributed to an expected further increase in real GDP growth in 2011, despite an anticipated decline in the impetus from fiscal policy."

But among the Fed governors and presidents, "many participants noted that the economic recovery was likely to be quite restrained."

Bank credit was seen as still "difficult to obtain and costly for many borrowers" and it was expected that credit conditions will "improve only gradually." FOMC participants believed "consumers were likely to be cautious in spending, and business contacts indicated that their firms would also be cautious in hiring and investing even as demand for their products picked up."

"Participants generally expected no more than moderate growth in consumer spending over the near term," say the minutes, which cite "considerable headwinds" -- "tight credit, high levels of debt, uncertain job prospects, and wealth levels that remained relatively low despite the recent rise in equity prices and stabilization in house prices."

The American savings rate had already risen, it was noted, and some warned "there was some chance that the sharp drop in household net worth over the past few years, reduced access to credit, and high household debt burdens could lead households to save a substantially larger fraction of their incomes going forward."

Nor was there a lot of hope for business investment. Business "caution, together with low utilization rates and substantial excess capacity, could hold back the rate of increase of new capital spending," the minutes say.

The minutes show there was suspicion that the private sector has been propped up by various government programs and has yet to gain any sustainable traction of its own.

"Some of the recent gains in activity probably reflected government policy support, and participants expressed considerable uncertainty about the likely strength of the upturn once those supports were withdrawn or their effects waned," say the minutes.

"Overall, the economy was projected to expand over the remainder of 2009 and during 2010, but at a pace that was unlikely to reduce the unemployment rate appreciably," the minutes continue. "Subsequently, as the housing market picked up further and financial conditions improved, economic growth was expected to strengthen, leading to more-substantial increases in resource utilization over time."

But there seemed not to be a lot of confidence that housing will pick up significantly.

"Participants welcomed the cumulating evidence that the housing sector was beginning to recover, and many participants had marked up their forecasts for housing activity," say the minutes. "However, some viewed the improvement as quite tentative, pointing to the pending termination of the temporary tax credit for first-time homebuyers and the winding down of the Federal Reserve's agency MBS purchase program as potential risks to the outlook for the sector."

"Also, some participants questioned whether the recent stabilization in house prices would be sustained as likely further increases in foreclosures would probably put downward pressure on prices."

Against that backdrop of wariness and uncertainty about sustainable recovery, inflation was only a distant worry at the September 22-23 FOMC meeting. "Most participants anticipated that slack in both labor and product markets would be substantial over the next few years, leading to subdued and potentially declining wage and price inflation."

Some participants -- undoubtedly Fed presidents like Philadelphia Charles Plosser -- questioned relying on "slack" as an inflation dampener, but they were clearly in the minority.

There was broader agreement on the importance of keeping inflation expectations anchored and on the need to "carefully monitor" them.

For that reason, "all agreed on the importance of the Federal Reserve continuing to communicate that it has the tools and willingness to begin withdrawing monetary policy accommodation at the appropriate time and pace to prevent any persistent increase in inflation."

Summarizing members views on inflation, the minutes say "many participants viewed the risks to their inflation outlook over the next few quarters as being roughly balanced. A few continued to see some risk of substantial further disinflation, but that risk had eased somewhat further over the intermeeting period. Over a longer horizon, a few felt the risks were tilted to the upside."

Developments in financial markets were "regarded as broadly positive" with "substantial" improvement in market functioning and pricing since the spring.

But the decline in yields on Treasury and other bonds that had occurred in the run-up to the meeting was seen as "puzzling," albeit "supportive of recovery."

-more- (1 of 2)

** Market News International **