Recently released minutes from the FOMC’s August 7 policy meeting show that the Federal Reserve is becoming increasingly concerned about the impact of the mortgage crisis on the overall economy. It’s interesting to note that the Committee still saw inflation as the primary risk at that time, although that stance seems to have changed quickly in light of a 50 basis point cut in the discount rate on August 17. Relevant highlights from the minutes:

Demand for housing in the second quarter was restrained by higher interest rates and by tightening credit conditions in the subprime mortgage market … Financial market conditions were volatile during the intermeeting period, particularly over the last few weeks of the interval … Conditions in markets for subprime mortgages and related instruments, including segments of the asset-backed commercial paper market, deteriorated sharply toward the end of the period … Mortgage loans and consumer credit appeared to remain readily available to households with strong balance sheets, although late in the period some evidence pointed to diminishing availability of jumbo mortgages. Participants agreed that the housing sector was apt to remain a drag on growth for some time and represented a significant downside risk to the economic outlook [emphasis added]. Indeed, developments in mortgage markets during the intermeeting period suggested that the adjustment in the housing sector could well prove to be both deeper and more prolonged than had seemed likely earlier this year …

That last part represents a sea-change in previous thinking from the Fed, and is something that probably has become the foremost issue right now for the Committee to address in its upcoming meeting.