WASHINGTON — Given new expectations that the U.S. economy could contract for as much as a year, Federal Reserve officials stand ready to slash interest rates to levels not seen in half a century, minutes of their most recent policy meeting show.

Meanwhile, officials suggested that the economy could be in for a rather lengthy recession and sharplydowngraded their economic forecasts. The minutes, which were released Wednesday with the customary three-week lag, show that officials generally expect the economy to contract in the second half of 2008 and the first half of 2009. And some officials expect that the economic weakness “could persist for some time.”

Some officials voiced concern that future cuts might do little to put the ailing economy on a healthier path, according to the minutes. And with the target federal funds rate already at 1%, some officials pointed out that the Fed has “limited room” to lower further and should therefore move slowly. Still, others said more aggressive easing could help reduce borrowing costs as well as the odds of a deflationary outcome.

Either way, the Fed has made it clear that it is “unequivocally biased” to further rate cuts, wrote UniCredit Markets and Investment Banking economist Harm Bandholz in a research note.

“The minutes show that not even this historically low level has to be the end of the Fed’s easing cycle,” said Bandholz, adding that he expects the Fed to cut its target rate another 50 basis points at officials’ Dec. 16 meeting.

In their Oct. 28-29 meeting, officials said that “unfolding economic developments” could require the Federal Open Market Committee “to further lower its target for the federal funds rate in the future and to review the adequacy of its liquidity facilities.”

Fed officials said they anticipate that economic data would show “significant weakness in economic activity” and that additional policy easing could well be necessary, according to the meeting minutes.

Meanwhile, they said they expect inflation to diminish in coming quarters.

“In any event, the committee agreed that it would take whatever steps were necessary to support the recovery of the economy,” the minutes said.

Overall, officials found that risks to the economy had greatly escalated and the credit crisis had morphed into an “international phenomenon,” leaving them little choice but to cut interest rates to four-year lows.

As the credit crisis worsened last month, the FOMC voted unanimously Oct. 29 to lower the target federal-funds rate at which banks lend to each other by 0.5 percentage point to 1%, its lowest level since the period between June 2003 and June 2004. The decision came in wake of Lehman Brothers Holdings Inc.’s (LEHMQ) September collapse, the near-failure of insurer American International Group Inc. (AIG) and new concerns about the conditions of other financial firms.

The Fed officials agreed that “significant easing in policy was warranted at this meeting in view of the marked deterioration in the economic outlook and anticipated reduction in inflation pressures,” the minutes said.

They also noted that the credit crisis expanded globally since their September policy meeting, at which they held rates steady.

“The strains from the banking and credit crisis intensified and took on a more global aspect over the intermeeting period,” the minutes said. “This development and the related erosion of the economic outlook and reduction in inflationary pressures led many central banks to reduce their policy rates, including in the internationally coordinated action announced on Oct. 8.” That day, Fed officials agreed to an unprecedented joint rate cut with other major central banks including the European Central Bank and Bank of England.

Meanwhile, the Fed downgraded its 2008 forecasts for gross domestic product and the unemployment rate, according to a quarterly forecast the Fed released Wednesday.

The central tendency of officials’ forecast is for gross domestic product growth this year to stand between 0.0% and 0.3%, which is lower than its June projection of a 1.0% to 1.6% range.

Meanwhile, they slashed their GDP growth projection for 2009 to a range of -0.2% to 1.1%. In June, they had seen a 2.0% to 2.8% range for 2009.

Officials also raised their forecasts for the unemployment rate. They now see the unemployment rate between 6.3% and 6.5% in 2008, up from the previous forecast of 5.5% to 5.7%, the Fed said.

Amid a deteriorating economy, the unemployment rate had already surpassed the Fed’s previous forecast. Earlier this month, the Labor Department reported that the unemployment rate in October soared 0.4 percentage point to 6.5%, the highest level since March 1994.

By Maya Jackson Randall
Of DOW JONES NEWSWIRES