The U.S. Federal Reserve is prepared to cut interest rates again if the economic picture continues to worsen, minutes of their most recent policy meeting show.

Fed officials generally expected the economy to contract in the second half of 2008 and the first half of 2009, according to the minutes from the FOMC Oct. 28-29 meeting, which were released Wednesday.

And some officials expected that the economic weakness “could persist for some time,” according to the minutes.

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.

“In any event, the committee agreed that it would take whatever steps were necessary to support the recovery of the economy,” the minutes said, indicating that the Fed may lower its target for the federal funds rate.

Overall, officials found that risks to the economy had greatly escalated, leaving them little choice but to cut interest rates to four-year lows. As the credit crisis worsened, 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 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.

In a special report released Wednesday, TD Bank economists say that with the fed funds rate at 1% and poised to go lower, the Fed may have to turn to some of its more esoteric tools to try and stimulate the economy.

At its most recent rate decision, the Fed lowered the fed funds rate by 50 bps to 1.00% and left the door open for further cuts, TD notes. It predicts that another 50 bps easing is in the pipeline, but says that there is the possibility that the Fed needs to ease more and could even take the fed funds rate to zero.

A zero interest rate policy (ZIRP) is certainly possible, TD says, noting that statements from various Fed officials have confirmed that the Fed does not see the current 1% level of the fed funds rate as the definitive bottom.

That said, TD spells out various obstacles that it sees for the Fed in going lower than 50 bps. “The marginal economic stimulus that a final cut by 50bps to 0% might provide would have to be weighed against the costs for different sectors of the financial system,” it says, pointing out that such a move could impact lending that’s geared off the fed funds rate, it would also sharply dilute the security of returns that money market funds are supposed to deliver, and it could hurt the short term funding market, among other things.

Given these possible negative consequences, TD says it’s doubtful that the Fed will cut all the way to zero. Instead, there are a number of possible policy alternatives, it says. Among the other things the Fed could do, TD says, includes: talking down long-term interest rates; it could target an interest rate further out the yield curve by buying as many securities as necessary at the given maturity to bring down that rate; or, economic stimulus could be achieved by having the Fed directly purchase new debt from the Treasury.

“The Fed is not out of tools to fight the battle ahead, but the tools necessary are certainly exceptional,” TD concludes.

IE