At its December meeting, the FOMC lowered its target for the federal funds rate 25 basis points, to 4-1/4 percent. In addition, the Board of Governors approved a decrease of 25 basis points in the discount rate, to 4-3/4 percent, leaving the gap between the federal funds rate target and the discount rate at 50 basis points. The Committee's statement noted that incoming information suggested that economic growth was slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets had increased in recent weeks. The Committee indicated that its action, combined with the policy actions taken earlier, should help promote moderate growth over time. Readings on core inflation had improved modestly during the year, but elevated energy and commodity prices, among other factors, might put upward pressure on inflation. In this context, the Committee judged that some inflation risk remained and said that it would continue to monitor inflation developments carefully. Recent developments, including the deterioration in financial market conditions, had increased the uncertainty surrounding the outlook for economic growth and inflation. The Committee stated that it would continue to assess the effects of financial and other developments on economic prospects and would act as needed to foster price stability and sustainable economic growth.
Over the intermeeting period, the expected path of monetary policy over the next year as measured by money market futures rates tilted down sharply, primarily in response to softer-than-expected economic data releases. The Committee's action at its December meeting was largely anticipated by market participants, although some investors were surprised by the absence of any indication of accompanying measures to address strains in term funding markets. Some of that surprise was reversed the next day, following the announcement of a Term Auction Facility (TAF) and associated swap lines with the European Central Bank and the Swiss National Bank. The subsequent release of the minutes of the meeting elicited little market reaction. However, investors did mark down the expected path of policy in response to speeches by Federal Reserve officials; the speeches were interpreted as suggesting that signs of broader economic weakness and additional financial strains would likely require an easier stance of policy. The Committee's decision to reduce the target federal funds rate 75 basis points on January 22 surprised market participants and led investors to mark down further the path of policy over the next few months. Consistent with the shift in the economic outlook, the revision in policy expectations, and the reduction in the target federal funds rate, yields on nominal Treasury coupon securities declined substantially over the period since the December FOMC meeting. The yield curve steepened somewhat further, with the two-year yield dropping more than the ten-year yield. Near-term inflation compensation increased in early January amid rising oil prices, but it retreated in later weeks, along with oil prices, and declined, on net, over the period.
Conditions in short-term funding markets improved notably over the intermeeting period, but strains remained. Spreads of rates on securities in interbank funding markets over risk-free rates narrowed somewhat following the announcement of the TAF on December 12 and eased considerably after year-end, although they remained at somewhat elevated levels. Spreads of rates on asset-backed commercial paper over risk-free rates also fell, on net, and the level of such paper outstanding increased in the first two weeks of January for the first time since August. In longer-term corporate markets, yields on investment-grade corporate bonds fell less than those on comparable-maturity Treasury securities, while yields on speculative-grade bonds rose considerably. As a result, corporate bond spreads climbed to their highest levels since early 2003, apparently reflecting increased concern among investors about the outlook for corporate credit quality over the next few years. Nonetheless, gross bond issuance in December remained strong. Commercial bank credit expanded briskly in December, supported by robust growth in business loans and in nonmortgage loans to households, and in the face of survey reports of tighter lending conditions. Over the intermeeting period, spreads on conforming mortgages over comparable-maturity Treasury securities remained about flat, as did spreads on jumbo mortgages, although credit availability for jumbo-mortgage borrowers continued to be tight. Broad stock price indexes fell over the intermeeting period on perceptions of a deteriorating economic outlook and additional write-downs by financial institutions. Similar stresses were again evident in the financial markets of major foreign economies. The trade-weighted foreign exchange value of the dollar against major currencies declined slightly, on balance, over the intermeeting period.
Debt in the domestic nonfinancial sector was estimated to have increased somewhat more slowly in the fourth quarter than in the third. The rate of increase of nonfinancial business debt decelerated in the fourth quarter from its rapid third-quarter pace despite robust bond issuance as the rise in commercial and industrial lending moderated. Household mortgage debt expanded at a slow rate in the fourth quarter, reflecting continued weakness in home prices, declining home sales, and tighter credit conditions for some borrowers. Nonmortgage consumer credit appeared to expand at a moderate pace. In December, the increase in M2 was up slightly from its November pace, boosted primarily by inflows into the relative safety and liquidity of money market mutual funds. The rise in small time deposits moderated but remained elevated, as several thrift institutions offered attractive deposit rates to secure funding. In contrast, liquid deposits continued to increase weakly and currency contracted noticeably, the latter apparently reflecting an ongoing trend in overseas demand away from U.S. dollar bank notes and towards the euro and other currencies.
In the forecast prepared for this meeting, the staff revised up slightly its estimated increase in aggregate economic activity in the fourth quarter of 2007 but revised down its projected increase for the first half of 2008. Although data on consumer spending and nonresidential construction activity for the fourth quarter had come in above the staff's expectations, most of the information received over the intermeeting period was weaker than had been previously expected. The drop in housing activity continued to intensify, conditions in labor markets appeared to have deteriorated noticeably near year-end, and factory output had weakened. Consumer confidence remained low, and indicators of business sentiment had worsened. Equity prices had also fallen sharply so far in 2008, and, while the functioning of money markets had improved, conditions in some other financial markets had become more restrictive. The staff projection showed the weakness in spending dissipating over the second half of 2008 and 2009, in response to the cumulative easing of monetary policy since August, the abatement of housing weakness, a lessening drag from high oil prices, and the prospect of fiscal stimulus. Still, projected resource utilization was lower over the next two years than in the previous forecast. The projection for core PCE price inflation in 2008 was raised slightly in response to elevated readings in recent months. The forecast for headline PCE price inflation also incorporated a somewhat higher rate of increase for energy prices for the first half of 2008; as a result, headline PCE price inflation was now expected to exceed core PCE price inflation slightly for that year. The forecasts for both headline and core PCE price inflation for 2009 were unchanged, with both receding from their 2008 levels.
In conjunction with the FOMC meeting in January, all meeting participants (Federal Reserve Board members and Reserve Bank presidents) provided annual projections for economic growth, unemployment, and inflation for the period 2008 through 2010. The projections are described in the Summary of Economic Projections, which is attached as an addendum to these minutes.
In their discussion of the economic situation and outlook, and in the projections that they had submitted for this meeting, participants noted that information received since the December meeting had been decidedly downbeat on balance. In particular, the drop in housing activity had intensified, factory output had weakened, news on business investment had been soft, and conditions in labor markets appeared to have deteriorated. In addition, consumer confidence had remained low and business confidence appeared to have worsened. Although the functioning of money markets had improved notably, strains remained evident in a number of other financial markets, and credit conditions had become generally more restrictive. Against this backdrop, participants expected economic growth to remain weak in the first half of this year before picking up in the second half, aided in part by a more accommodative stance of monetary policy and by likely fiscal stimulus. Further ahead, participants judged that economic growth would continue to pick up gradually in 2009 and 2010. Nonetheless, with housing activity and house prices still declining and with financial conditions for businesses and households tightening further, significant uncertainties surrounded this outlook and the risks to economic growth in the near term appeared to be weighted to the downside. Indeed, several participants noted that the risks of a downturn in the economy were significant. Inflation data had been disappointing in recent months, and a few participants cited anecdotal reports that some firms were able to pass on costs to consumers. However, with inflation expectations anticipated to remain reasonably well anchored, energy and other commodity prices expected to flatten out, and pressures on resources likely to ease, participants generally expected inflation to moderate somewhat in coming quarters.
Meeting participants observed that conditions in short-term funding markets had improved considerably since the December meeting, reflecting the easing of pressures related to funding around the turn of the year as well as the implementation of the TAF. However, broader financial conditions had tightened significantly, on balance, in the weeks leading up to the meeting, as evidence of further deterioration in housing markets and investors' more pessimistic view of the economic outlook adversely affected a range of financial markets. Many participants were concerned that the drop in equity prices, coupled with the ongoing decline in house prices, implied reductions in household wealth that would likely damp consumer spending. Moreover, elevated volatility in financial markets likely reflected increased uncertainty about the economic outlook, and that greater uncertainty could lead firms and households to limit spending. The availability of credit to consumers and businesses appeared to be tightening, likely adding to restraint on economic growth. Participants discussed the risks to financial markets and institutions posed by possible further deterioration in the condition of financial guarantors, and many perceived a possibility that additional downgrades in these firms' credit ratings could put increased strains on financial markets. To be sure, some positive financial developments were evident. Banks appeared to be making some progress in strengthening their balance sheets, with several financial institutions able to raise significant amounts of capital to offset the large losses they had suffered in recent quarters. Nevertheless, participants generally viewed financial markets as still vulnerable to additional economic and credit weakness. Some noted the especially worrisome possibility of an adverse feedback loop, that is, a situation in which a tightening of credit conditions could depress investment and consumer spending, which, in turn, could feed back to a further tightening of credit conditions.
In their discussion of individual sectors of the economy, meeting participants emphasized that activity in housing markets had continued to deteriorate sharply. With single-family permits and starts still falling, sales of new homes dropping precipitously, sales of existing homes flat, and inventories of unsold homes remaining elevated even in the face of falling house prices, several participants noted the absence of signs of stabilization in the sector. Of further concern were the reduced availability of nonconforming loans and the apparent tightening by banks of credit standards on mortgages, both of which had the potential for intensifying the housing contraction. The recent declines in interest rates had spurred a surge in applications for mortgage refinancing and would limit the upward resets on the rates on outstanding adjustable-rate mortgages, both of which would tend to improve some households' finances. Nonetheless, participants viewed the housing situation and its potential further effect on employment, income, and wealth as one of the major sources of downside risk to the economic outlook.
Recent data as well as anecdotal information indicated that consumer spending had decelerated considerably, perhaps partly reflecting a spillover from the weakness in the housing sector. Participants remarked that declining house prices and sales appeared to be depressing consumer sentiment and that the contraction in wealth associated with decreases in home and equity prices probably was restraining spending. In addition, consumption expenditures were being damped by slower growth in real disposable income induced by high energy prices and possibly by a softening of the labor market. The December employment report showed that job growth had slowed appreciably, and other indicators also pointed to emerging weakness in the labor market in the intermeeting period. And spending in the future could be affected by an ongoing tightening in the availability of consumer credit amid signs that lenders were becoming increasingly cautious in view of some deterioration of credit performance on consumer loans and widening expectations of slower income growth. Some participants, however, cited evidence that workers in some sectors were still in short supply and saw signs that the labor market remained resilient.
The outlook for business investment had turned weaker as well since the time of the December meeting. Several participants reported that firms in their districts were reducing capital expenditures in anticipation of a slowing in sales. Manufacturing activity appeared to have slowed or contracted in many districts. Although a few participants reported more upbeat attitudes among firms in the technology and energy sectors, business sentiment overall appeared to be declining. Moreover, a number of indicators pointed to a tightening in credit availability to businesses. For example, the Senior Loan Officer Opinion Survey on Bank Lending Practices indicated that banks had tightened lending standards and pricing terms on business loans. Lending standards had been raised especially sharply on commercial real estate loans. While real outlays for nonresidential construction apparently continued to rise through the fourth quarter, anecdotal evidence pointed to a weakening of commercial real estate spending in several districts, with some projects being canceled or scaled back.
Most participants anticipated that a fiscal stimulus package, including tax rebates for households and bonus depreciation allowances for businesses, would be enacted before long and would support economic growth in the second half of the year. Some pointed out, however, that the fiscal stimulus package might not help in the near term, when the risks of a downturn in economic activity appeared largest. In addition, the effects of the proposed package would likely be temporary, with the stimulus reversing in 2009.