The decisions of the Federal Open Market Committee (FOMC) at its December 15-16 meeting reportedly were more aggressive than investors had been expecting. Market participants reportedly were somewhat surprised both by the size of the reduction in the target federal funds rate, to a range of 0 to 1/4 percent, and by the statements that policy rates would likely remain low for some time and that the FOMC might engage in additional nontraditional policy actions such as the purchase of longer-term Treasury securities. Over the intermeeting period, investors marked down their expectations for the path of the federal funds rate, as measured by money market futures rates. The path first moved down immediately after the December FOMC meeting. Later in the period, the policy path tilted lower in response to weaker-than-expected economic data releases and increased concerns about the health of some financial institutions. In contrast, yields on medium- and longer-term nominal Treasury coupon securities increased, on net, over the period. Yields dropped sharply following the release of the FOMC statement, reportedly in part because investors interpreted it as suggesting that the Federal Reserve might increase its holdings of longer-term Treasury securities. Those price movements were more than reversed after the turn of the year, despite the worsening economic outlook, apparently reflecting a waning of year-end safe-haven demands and an anticipation of substantially increased Treasury debt issuance to finance larger-than-expected deficits associated with the new Administration's economic stimulus plans. Although implied inflation compensation derived from Treasury Inflation-Protected Securities (TIPS) increased over the period, this increase reportedly was largely attributable to improved trading conditions in the TIPS market rather than upward revisions to inflation expectations.
Conditions in short-term funding markets showed some signs of easing, although significant stresses remained. The spreads of London interbank offered rates, or Libor, over comparable-maturity overnight index swap rates declined across most maturities over the period: The one-month spread fell to its lowest level since August 2007; the three-month spread also declined but remained elevated. Though depository institutions continued to make substantial use of the discount window, the amount of primary credit outstanding declined. Recent auctions of term funds under the Federal Reserve's Term Auction Facility were undersubscribed, although one auction following the year-end did see a relatively large number of bidders. The TSLF auctions were also undersubscribed. Use of the PDCF continued to fall significantly over the period.
Conditions in markets for repurchase agreements, or repos, also showed some signs of improvement. With the overnight Treasury general collateral repo rate near zero for much of the period, market participants reportedly were reluctant to lend Treasury collateral out of concern that counterparties might fail to return borrowed securities. However, the pace of delivery fails continued to run well below the high rates of September and October, reflecting in part reductions in transaction volumes as well as industry efforts to mitigate fails, including the January 5 recommendation of the Treasury Market Practices Group to implement a financial charge on settlement fails. Conditions in the market for repo transactions backed by agency debt and mortgage-backed securities also improved somewhat, with average bid-asked spreads declining from high levels.
The market for Treasury coupon securities showed signs of increased impairment late in 2008, followed by some improvement early in 2009. Trading volumes fell to very low levels at the end of 2008, although they recovered a bit after the end of the year. Bid-asked spreads in the on-the-run market declined sharply at the beginning of 2009 after having increased at the end of 2008. The on-the-run premium for the 10-year nominal Treasury note was little changed at very elevated levels over the intermeeting period. On balance, the Treasury market remained much less liquid than normal.
Treasury- and government-only money market mutual funds (MMMFs) faced pressures stemming from very low short-term interest rates, and many such funds reportedly had waived management fees in an effort to retain investors. By contrast, prime MMMFs had net inflows over the intermeeting period. The MMIFF continued to register no activity despite changes that eased some of the terms of the program. Market participants nonetheless pointed to the MMIFF as a potentially important backup facility.
Conditions in the commercial paper (CP) market improved over the intermeeting period, likely reflecting recent measures taken in support of this market, greater demand from institutional investors, and the passing of year-end. Yields and spreads on 30-day A1/P1 nonfinancial and financial CP as well as on asset-backed commercial paper (ABCP) declined modestly and remained low. Yields and spreads on 30-day A2/P2 CP, which is not eligible for purchase under the CPFF, dropped sharply after the beginning of the year as some institutional investors reportedly reentered the market. The dollar amounts of outstanding unsecured financial and nonfinancial CP and ABCP rose slightly, on net, over the intermeeting period. This small change was more than accounted for by the increase in CP held by the CPFF. In contrast, credit extended under the AMLF declined over the intermeeting period.
Liquidity in the corporate bond market improved over the intermeeting period, with increases in trading volume for both investment- and speculative-grade bonds and declines in bid-asked spreads for speculative-grade bonds. Yields and spreads on corporate bonds decreased noticeably, particularly for speculative-grade firms, but spreads remained high by historical standards. Gross issuance of bonds by nonfinancial investment-grade companies remained solid, but issuance of speculative-grade bonds was limited. Conditions in the leveraged loan market remained very poor and issuance of leveraged syndicated loans was also very weak. Secondary market prices for leveraged loans stayed near record lows and the average bid-asked spread in that market continued to be very wide. The market for commercial mortgage-backed securities (CMBS) continued to show signs of strain, with the CMBX index--an index based on credit default swap (CDS) spreads on AAA-rated CMBS--widening during the intermeeting period from already very elevated levels.
Broad equity market indexes fell over the intermeeting period. After improving during the early part of the intermeeting period, market sentiment toward financial firms appeared to worsen later in the period. Those firms substantially underperformed the broader market as a number of large and regional banks reported sizable losses stemming from weak trading results, asset write-downs, and additional increases in loan-loss provisions in anticipation of a further deterioration in credit quality. CDS spreads for U.S. bank holding companies rose sharply in mid-January to near their historical highs, and equity prices for such companies fell on net, ending the period below their November lows. A number of banking organizations issued debt through the FDIC's Temporary Liquidity Guarantee Program; spreads on such debt declined to levels close to those on agency debt. The Treasury's Troubled Asset Relief Program provided additional support to several banking institutions. In particular, to support financial market stability, the Treasury, the FDIC, and the Federal Reserve announced on January 16 that they had entered into an agreement with Bank of America to provide a package of guarantees, liquidity access, and capital. Developments at nonbank financial institutions were mixed. Equity prices of insurance companies edged down over the period, while their CDS spreads declined from extremely high levels. Hedge funds posted negative average returns in December.
Debt of the domestic nonfinancial sectors expanded at a somewhat faster pace in the fourth quarter of 2008 than in the first three quarters of the year. Borrowing by the federal government continued to surge, boosted by programs aimed at reducing financial market strains. Borrowing by state and local governments picked up as the conditions in municipal bond market improved somewhat. Household debt appeared to have contracted in the fourth quarter, with both mortgage and consumer credit sharply curtailed due to weak household spending and tight credit conditions. Business debt expanded only modestly, given the high cost of borrowing, tighter lending terms, and the deterioration in the macroeconomic environment.
Commercial bank credit fell for the second consecutive month in December. Commercial and industrial loans declined in November and December, likely reflecting a combination of tighter credit supply and reduced loan demand as well as some unwinding of the surge during September and October. The Senior Loan Officer Opinion Survey conducted in January indicated that banks had continued to tighten credit standards and terms on all major loan categories over the past three months. Survey respondents also indicated that they had reduced the size of credit lines for a wide range of existing business and household customers.
M2 expanded at a considerably more rapid pace in December than in previous months. Flows into both demand deposits and savings deposits surged, possibly reflecting a reallocation of wealth towards assets that had government insurance or guarantees. Small time deposits also increased strongly, as banks continued to bid aggressively for these deposits. Currency continued to grow briskly, apparently boosted by solid foreign demand for U.S. banknotes. In December, retail MMMF balances increased modestly after a decline in November.
Conditions in foreign financial markets were relatively calm over the intermeeting period, although concerns about bank earnings and the stability of the global banking system led to widespread declines in equity prices later in the period. Governments in major foreign economies initiated several actions aimed at strengthening the banking sector and easing credit market strains. Sovereign bond yields in the advanced foreign economies fell early in the period, likely reflecting declining inflation and expectations of lower policy rates, but moved up subsequently, perhaps in response to concerns about fiscal deficits. The dollar increased on balance against the currencies of major U.S. trading partners.
Staff Economic Outlook
In the forecast prepared for the meeting, the staff revised down its outlook for economic activity in the first half of 2009, as the implications of weaker-than-anticipated economic data releases more than offset an upward revision to the staff's assumption of the amount of forthcoming fiscal stimulus. Conditions in the labor market deteriorated sharply over the intermeeting period. Industrial production declined steeply, and household and business spending fell more than anticipated. Sales and starts of new homes remained on a steep downtrend. Foreign demand also was weaker than expected. Financial markets continued to be strained overall, credit remained unusually tight for both households and businesses, and equity prices had fallen further. The staff's projections of real GDP growth in the second half of 2009 and in 2010 were revised upward slightly, reflecting greater monetary and fiscal stimulus as well as the effects of more moderate oil prices and long-term interest rates, but they continued to show no more than a gradual economic recovery. The staff again expected that unemployment would rise substantially through the beginning of 2010 before edging down over the remainder of that year. Forecasts for core and overall PCE inflation in 2009 and 2010 were little changed, with growth in both core and overall PCE prices expected to be unusually low over the next few years in response to slack in resource utilization and relatively flat prices anticipated for many commodities and for imports.
Meeting Participants' Views and Committee Policy Action
In conjunction with this FOMC meeting, all meeting participants-the four members of the Board of Governors and the presidents of the twelve Federal Reserve Banks-provided projections for economic growth, the unemployment rate, and consumer price inflation for each year from 2009 through 2011. To provide the public with information about their views of likely longer-term economic trends, and as additional context for the Committee's monetary policy discussions, participants agreed to collect and publish, on a quarterly basis, projections of the longer-run values to which they expect these three variables to converge. Participants' projections through 2011, and for the longer-run, are described in the Summary of Economic Projections that is attached as an addendum to these minutes.
In their discussion of the economic and financial situation and the outlook for the economy, participants agreed that the economy had weakened further going into 2009. The incoming data, as well as information received from contacts in the business and banking communities, indicated a sharp and widespread economic contraction both domestically and abroad, reflecting in large part the adverse effects of the intensification of the financial crisis and the interaction between deteriorating economic and financial conditions. Participants generally saw credit conditions as extremely tight, with financial markets fragile and some parts of the banking sector under substantial stress. However, modest signs of improvement were evident in some financial markets--particularly those that were receiving support from Federal Reserve liquidity facilities and other government actions. Participants anticipated that a gradual recovery in U.S. economic activity would begin during the third or fourth quarter of this year as the economy begins to respond to fiscal stimulus, relatively low energy prices, and continuing efforts to stabilize the financial sector and increase the availability of credit. Several participants noted that firms' efforts to control inventories as sales declined had contributed to the rapid downturn in production and employment in recent quarters, but expected that the resulting absence of widespread inventory overhangs might spur a prompt pickup in production in many sectors later this year once sales begin to level out or turn up. Headline inflation would pick up some as the effects of previous declines in oil and other commodity prices wore off. But in an environment of considerable economic slack, little if any inflation pressure from energy or other import prices, and possible declines in inflation expectations, headline and core inflation were expected to be quite low for several years. Participants were, however, quite uncertain about the outlook. All but a few saw the risks to growth as tilted to the downside; in light of financial stresses and tight credit conditions, they saw a significant risk that the economic recovery would be both delayed and initially quite weak. In particular, most participants saw the renewed deterioration in the banking sector's financial condition as posing a significant downside risk to the economic outlook absent additional initiatives to stabilize the banking system.