Fed December minutes signalled recession and deflation fears

The threat of recession and the spectre of deflation haunted members of the Federal Reserve's interest rate-setting committee, according to the minutes of their historic December meeting.

Amid growing signs of weakening economic activity, the minutes of the 15-16 December meeting were published yesterday, throwing new light on the decision to encourage zero per cent US interest rates, to end the practice of setting an explicit target for rates and instead putting the focus on central bank intervention across the credit markets.

Members of the Federal Open Market Committee (FOMC) saw the US economy threatening to be persistently weak into 2009, requiring the use of brand new monetary policy tools to try to reignite growth and prevent deflation.

"Even with the additional use of non-traditional policies, the economic outlook would remain weak for a time and the downside risks to economic activity would be substantial," the minutes of the discussion reported. "Moreover, inflation would continue to fall, reflecting both the drop in commodity prices that had already occurred and the build-up of economic slack. Indeed some members saw significant risks that inflation could decline and persist for a time at uncomfortably low levels."

The FOMC set a range of 0-0.25 per cent for the federal funds rate, preferring instead to try to reduce borrowing costs for homeowners and businesses by other measures, such as buying bonds in the open market.

The US economy has been in recession since December 2007, but the financial panic of last September caused it to take a new lurch downward and forecasters now believe the economy shrank at an annualised rate of about 6 per cent in the final quarter of last year.

There were very few shafts of light amid the gloomy economic data released yesterday. The service sector contracted in December for the third month in a row, and in the housing market, the number of home sales in the works is many fewer than expected.

The ISM service sector survey reading was at least not as bad as forecast for last month. At 40.6, versus November's record-low of 37.3, it showed the contraction decelerating rather than picking up pace, as economists had feared. A reading of 50 is the dividing line between growth and contraction. But the National Association of Realtors said its pending home sales index, based on contracts signed in November, dropped 4 per cent to 82.3, when economists had expected a drop of just 1 per cent.

New factory orders received by US manufacturers plunged 4.6 per cent, the fourth straight monthly decline and a sign the sharp drop in manufacturing is deepening the recession.