Despite inflation, Fed says 'relatively low' interest rates necessary 'for a time'

The Fed said that "conditions in short-term funding markets had improved considerably since the December meeting, reflecting the easing of pressures related to funding around the turn of the year as well as the implementation of the Term Auction Facility." However, the Fed added, "broader financial conditions had tightened significantly, on balance, in the weeks leading up to the meeting, as evidence of further deterioration in housing markets and investors' more pessimistic view of the economic outlook adversely affected a range of financial markets."

The markets' response to the Fed's minutes was muted, as the Dow held on to gains to close about 90 points higher to 12,247.26.

Fed two-step

Economist David H. Wang told BloggingStocks Wednesday, he sees "proportion and balance" in the Fed's most recent minutes.

"Clearly, the Fed is saying 'we know we're in the midst of a battle against contraction forces and we stand ready to act,'" Wang said. "But investors and traders should keep in mind that if for some reason inflation gets out of hand, they remain ready to re-raise rates. Unlike some who argue that the Fed is totally growth-oriented now, due to our housing and credit problems, the way I read the minutes is that the Fed has not forgotten about inflation."

Wang said Fed Reserve Governor William Poole's comments about 'living to regret a monetary policy that focuses on only one concern, recession,' speak to that attentiveness regarding inflation.

Still, Wang said the overall tone of the minutes provides enough evidence to suggest that the Fed will cut key, short-term interest rates by another 50 basis points when it meets next on March 18. Wang is predicting a 50-basis-point cut in the Fed Funds rate to 2.50% and the discount rate to 3.00%.

Biggest challenge: stimulate economy

Economist Steve Affinito agreed, arguing that the U.S. economy "is in the midst of trying to fight off one contraction force after another ... mortgage defaults, mortgage-backed securities defaults, constrained credit conditions, bond insurer liquidity, and slowing consumer spending."

"I'm a little more public policy-based than my good friend David Wang, so I'm going to argue for a 75 basis point cut in interest rates," Affinito said. "That's out there, I know, but the way I read the data, we've got to stimulate the demand in two areas, business and housing, and we've got to reduce the number of mortgage defaults by about 20-30%, at minimum, and one way to do that is to create a better yield spread by lowering short-term interest rates."

Inflation, Affinito added, will increase, "but mostly due to rising energy prices, not due to the Fed's monetary policy easing."

"The Fed can't pump more oil out of the ground. That's OPEC's job. In the meantime, and I've said this before, we're going to need all the stimulus we can get, monetary, fiscal, and otherwise, to keep this recession a short one, one that lasts only two quarters," Affinito said. "And at this juncture, if the Fed can limit the recession to two quarters, what an economic victory that would be."