April 8 (Bloomberg) -- Federal Reserve officials feared the U.S. economy might fall into a self-reinforcing cycle of rising unemployment and slumping business and consumer spending, making credit tighter in a weak financial system, minutes of the Federal Reserve’s March meeting show.

“Participants expressed concern about downside risks to an outlook for activity that was already weak,” minutes of the March 17-18 meeting released in Washington said. “Credit conditions remained very tight, and financial markets remained fragile and unsettled, with pressures on financial institutions generally intensifying.”

The outlook prompted the Federal Open Market Committee in a unanimous vote to boost its open-market purchases of bonds by $1.15 trillion, continuing its unprecedented increase in money supplied to the economy. The U.S. central bank has used its own balance sheet to provide financing for markets in commercial paper, asset-backed securities and mortgage bonds, markets it deems critical for financial stability and economic recovery.

“The economic recovery they saw in the second half of this year -- the one they had revised up even as growth turned out weaker than they thought in the fourth quarter -- is now gone,” said Christopher Low, chief economist at FTN Financial in New York. “The FOMC has been remarkably slow in reaching the same conclusions investors reached months ago.”

Fed’s Outlook

Fed governors and reserve bank presidents forecast annual growth rates of 2.5 percent to 3.3 percent in 2010 with a gradual recovery beginning in the second half of this year, according to the central tendency of their projections released in January minutes. The next forecasts will be published in minutes of the April Fed meeting.

“Most participants viewed downside risks as predominating in the near term, mainly owing to potential adverse feedback effects as reduced employment and production weighed on consumer spending,” the minutes said. “The decline in foreign economic activity was one of the most notable developments since the January meeting.”

Stock prices cut gains after the minutes were released. The Standard & Poor’s 500 Index rose 0.4 percent to 818.96 at 3:29 p.m. New York time, down from an intraday high of 828.42. U.S. Treasuries were higher, driving down yields. The benchmark 10- year note yielded 2.84 percent, down 6 basis points from yesterday.

MBS Purchases

The FOMC in March decided to purchase an additional $750 billion in mortgage-backed securities, bringing total purchases this year to $1.25 trillion, and to increase purchases of housing agency debt by $100 billion to $200 billion. The committee also decided to purchase $300 billion of longer-term Treasury securities over six months.

Fed credit to the economy stood at $2 trillion on April 1, up about $1.2 trillion over the past year. Fed officials have introduced new tools to help resolve liquidity shortages at banks and provide backstop financing.

The size of the Fed’s balance sheet and demand for central bank liquidity gave policy makers “evidence” that credit markets “still were not working well,” according to the minutes.

“There is no question that the whole tone is toward expanding the balance sheet further, and adding to the alphabet- soup list of programs,” former Atlanta Fed bank president William Ford said in a Bloomberg Television interview.

Housing Starts

Policy makers didn’t interpret a rise in housing starts in February as “the beginning of a new trend.”

The minutes also noted that Fed officials held a conference call on Feb. 7 to discuss the central bank’s participation in the Treasury Department’s financial stability plan.

The Fed last month started the Term-Asset Backed Securities Loan Facility to provide financing and investor support for securitized consumer debt. The program could grow to $1 trillion. “The demand for TALF funding appeared likely to be modest initially” because of investor fears of government intervention, the minutes said. “Other participants anticipated that TALF loans would increase over time.”

Yesterday’s second round of TALF lending saw requests from borrowers for loans drop 64 percent from last month to just $1.71 billion. The Fed provided $4.7 billion in loans in March to purchase securities in the TALF’s first monthly round.

TALF Expansion

Some officials also expressed concern that expanding the TALF program to include older, lower-quality assets as part of the administration’s financial-rescue plan might raise the central bank’s risk exposure, given “the greater uncertainty over the value of such assets.”

Fed officials last month kept the benchmark lending rate in a range of zero to 0.25 percent.

At the same time, officials are mapping out ways to withdraw monetary stimulus and retreat from credit programs once markets improve.

The Treasury and Fed published a joint agreement March 23 reinforcing the Fed’s independence on keeping inflation stable, and pledging to remove three emergency loan facilities on the Fed’s balance sheet created to support insurer American International Group Inc. and the merger of Bear Stearns Cos. with JPMorgan Chase & Co. a year ago.

Slumping home prices and the rise in mortgage delinquencies and foreclosures caused banks to pull back lending, accelerating an economic downturn that began in December 2007.

Job Cuts

The unemployment rate rose to 8.5 percent in March, the highest level since 1983. Employers cut 663,000 workers from payrolls, bringing total losses since the recession began to about 5.1 million, the biggest slump in the postwar era.

Gross domestic product slumped at a 5.5 percent annual rate in the first quarter, according to an April 6 estimate by Macroeconomic Advisers LLC.

The Fed staff revised down their outlook for the economy as their projections showed “the unemployment rate rising more steeply into early next year,” the minutes said. Policy makers expected further job cuts “though perhaps at a gradually diminishing rate.”

“Looking beyond the very near term, a number of market forces and policies now in place were seen as eventually leading to economic recovery,” the minutes said.

The Institute for Supply Management’s factory index climbed to 36.3 in March, a third consecutive increase. Purchases of existing homes rose 5.1 percent to an annual rate of 4.72 million in February as lower prices attracted buyers.

Consumers are also benefiting from lower energy costs and lower mortgage rates. The average rate on a U.S. 30-year fixed mortgage dropped to 4.78 percent last week, the lowest in Freddie Mac data going back to 1971.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net

Last Updated: April 8, 2009 15:39 EDT