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Fed Minutes: Credit Crunch Hurting Economic Growth

Members of the Federal Reserve's interest rate setting committee worried last month that a credit crunch could sharply brake economic growth and require big interest rate cuts, minutes of the U.S. central bank's December meeting released Wednesday show.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

"Some members noted the risk of an unfavorable feedback loop in which credit market conditions restrained economic growth further, leading to additional tightening of credit;
such an adverse development could require a substantial further easing of policy," the minutes said.

At the same time, members of the Fed's rate-setting Federal Open Market Committee realized that financial market conditions might improve more rapidly than they expected, which would make it appropriate to raise borrowing costs, reversing earlier cuts.

The Fed cut rates by a quarter-percentage point to 4.25 percent at the meeting.

Risks to growth had risen since their last meeting in large part due to deteriorating credit markets, the Fed said.

Even so, the policy-makers weighed the lagged impact of cumulative interest rate cuts, and a strong labor market, which suggested the economy retained some forward momentum. Overnight, interbank borrowing costs stood at 5.25 percent when the Fed began trimming borrowing costs in September.

"Members also recognized that financial market conditions might improve more rapidly than members expected, in which case a reversal of some of the rate cuts might become appropriate," the minutes said.

Earlier Wednesday, an industry report showed that U.S. factory activity contracted in December, ending 10 consecutive months of expansion, with activity falling to its weakest since April 2003.

Meanwhile, construction spending unexpectedly rose 0.1 percent in November despite ongoing
housing market woes that pushed private home building down 2.5 percent -- the sharpest drop in nearly six years, a Commerce Department report showed.

The Institute for Supply Management said its index of national factory activity fell to 47.7 in December from 50.8 in November, below economists' median forecast for a reading of 50.4. A reading below 50 indicates contraction in the sector.

New orders, a gauge of future growth, fell sharply to 45.7 last month -- its lowest since October 2001 -- from 52.6 in November.

The December employment index rose slightly to 48.0 from 47.8 in November, while the ISM prices paid index, which measures inflationary pressures within the factory sector, rose
to 68.0 in December from 67.5.

"It was a severe drop that seems to have been driven by declines in the most important component: orders," said Pierre Ellis, senior economist at Decision Economics in New York.

"Confidence that export- and investment-led growth will help the economy going forward will be weakened considerably by this report," Ellis said.

Economists polled by Reuters expected construction spending in November to fall 0.4 percent. November's increase to a $1.165 trillion seasonally adjusted annual rate came after a revised 0.4 percent decline in October, first estimated as a 0.8 percent decline.

Private home building fell to a $484.9 billion rate in November, the lowest since August 2003. This sector has fallen for 21st consecutive months since a peak in home building in
February 2006.

Despite the housing slump, private non-residential construction rose 1.7 percent to a record annual rate of $375.8 billion.

Public construction, too, rose in November with state and local government building up 2.5 percent while federal construction was up 2.2 percent.