Fed sees economy getting worse

• Hiring holds steady
• Half of 'rescued' borrowers still default
• Job outlook gets gloomier
• Where the jobs are
• Where the jobs are

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Bernanke: recession possible

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NEW YORK (CNNMoney.com) -- Some members of the Federal Reserve are worried about the possibility of a "severe and protracted downturn" in the U.S. economy that could last into next year, according to the minutes of the central bank's latest meeting released Tuesday.

The Fed said its staffers now expect the nation's gross domestic product (GDP) to shrink in the first half of this year, the clearest signal yet from the central bank that its members think the economy could be close to entering a recession -- if it hasn't already. Many Fed policymakers indicated that a downturn in the economy in the first half of the year "now appeared likely."

The minutes from the March 18 meeting show that some Fed policymakers are concerned the problems in the "housing sector had deepened and that considerable uncertainty surrounded the outlook for housing."

The release of the minutes come a week after Fed Chairman Ben Bernanke said during Congressional testimony that a "recession was possible." He also said that real GDP might grow slightly in the first half of the year but conceded that it could also contract.

The National Bureau of Economic Research is the official arbiter of when recessions begin and end and the NBER often does not declare an official recession until months after a downturn begins. But a common shorthand definition for a recession is two consecutive quarters of declines in GDP.

The Fed's forecasts for the rest of the year and next year are perhaps more worrisome, however. According to the minutes, the Fed said its staff is projecting only a slow rise in GDP in the second half of this year. It also said there is a risk that the economic slump could continue all the way into 2009.

The minutes pointed to the uncertainty in the battered housing and financial markets as the reason that the downturn could extend into next year.

"Several participants noted that the problems of declining asset values, credit losses, and strained financial market conditions could be quite persistent, restraining credit availability and thus economic activity for a time and having the potential subsequently to delay and damp economic recovery," the Fed said.

Fed members also conceded that even with its policy of aggressive rate cuts, the Fed may not be equipped to deal with more problems in these markets.

The Fed cut its key federal funds rate by three-quarters of a point at the March 18 meeting, its sixth rate cut since September.

The Fed has been cutting rates in an effort to keep the U.S. economy from falling into recession following the meltdown of the subprime mortgage market and resulting credit crunch.

Pessimism surprises Fed watchers

Fed watchers said they were taken aback by the new, grimmer view of the economy presented in the minutes, especially since some on Wall Street have been expressing hope that the worst may be over following the Fed's rescue of embattled investment bank Bear Stearns.

"They were more blunt, more pessimistic than I thought they would be," said David Wyss, chief economist with Standard & Poor's.

The Fed agreed to lend up to $29 billion to JPMorgan Chase last month to help it buy Bear Stearns and keep it from bankruptcy. There was no indication of any debate about this unprecedented move in the minutes.

John Silvia, chief economist for Wachovia, also said he was surprised by the Fed's tone. But he said he does not expect the Fed to cut rates aggressively at the conclusion of a two-day meeting later this month.

He's forecasting a quarter of a percentage point cut in the federal funds rate -- to 2%. Others on Wall Street also thinks a quarter-point cut is the most likely outcome after the Fed wraps up its meeting on April 30 as well. According to futures trading on the Chicago Board of Trade, investors are pricing in a 100% chance of a quarter-point cut but only a 44% chance of a half-point cut.

But that's up from only a 20% chance of a half-point cut as recently as last week. And Silvia thinks another cut at the Fed's meeting in June is now possible as the Fed continues to weigh concerns about the slowdown with fears of rising commodity prices and a weak dollar.

"I think that the committee is going to drag its feet. There are enough people on there concerned about the inflation risks longer term," said Silvia.

To that end, despite the growing belief that the economy is already in recession, the presidents of the Dallas and Philadelphia Federal Reserve Banks voted against cutting rates by three-quarters of a point last month, a rare amount of dissent on the central bank.