At its October 28-29 meeting, the Federal Open Market Committee (FOMC) lowered its target for the federal funds rate 50 basis points to 1 percent. The Committee's statement noted that economic activity appeared to have slowed markedly, due importantly to a decline in consumer expenditures. Business equipment spending and industrial production had weakened in recent months, and slowing economic activity in many foreign economies was damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil was likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. The Committee noted that, in light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, it expected inflation to moderate in coming quarters to levels consistent with price stability. The Committee also noted that recent policy actions, including the rate reduction that was approved at the October 28-29 meeting, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to economic activity remained and the Committee indicated that it would monitor economic and financial developments carefully and act as needed to promote sustainable economic growth and price stability.
Over the intermeeting period, investors marked down their expectations for the path of monetary policy. Policy expectations were largely unaffected by the outcome of the October 28-29 FOMC meeting, as the Committee's decision to reduce the target federal funds rate was broadly anticipated and the accompanying statement was reportedly in line with investor expectations. Subsequently, however, the expected future path of monetary policy dropped amid data releases that suggested a weaker outlook for economic activity and lower inflation than had been anticipated, along with continued strains in financial markets that weighed on investor sentiment. Yields on nominal Treasury coupon securities declined significantly over the intermeeting period in response to safe-haven demands as well as the downward revisions in the economic outlook and the expected policy path. Meanwhile, yields on inflation-indexed Treasury securities declined by smaller amounts, leaving inflation compensation lower. Although the decline in inflation compensation occurred amid sharp decreases in inflation measures and energy prices, it was likely amplified by increased investor preference for the greater liquidity of nominal Treasury securities relative to that of inflation-protected Treasury securities.
Conditions in short-term funding markets remained strained for most of the intermeeting period, though some signs of improvement were evident. The spreads of London interbank offered rates, or Libor, over comparable-maturity overnight index swap rates declined noticeably across most maturities early in the intermeeting period; however, some of this decline was reversed once maturities began to lengthen past year-end. Trading in longer-term interbank funding markets reportedly remained thin. Credit outstanding under the Federal Reserve's Term Auction Facility (TAF) increased to about $448 billion because of expanded auction sizes. Recent auctions for both 28-day and 84-day credit from the TAF were undersubscribed, and bidding for the two forward TAF auctions during the intermeeting period was very light. Meanwhile, primary credit outstanding remained high, although it had declined somewhat in recent weeks. Use of the Primary Dealer Credit Facility dropped significantly. A number of the Term Securities Lending Facility (TSLF) auctions were oversubscribed, as was the auction of options for 13-day Schedule 2 TSLF loans straddling the end of the year.
Conditions in markets for repurchase agreements, or repos, arranged using certain types of collateral deteriorated over the intermeeting period, and liquidity for repos backed by non-Treasury, non-agency collateral remained poor. Amid high demand for safe investments, the overnight Treasury general collateral (GC) repo rate remained very low and fell to around zero late in the intermeeting period. Still, failures to deliver in the Treasury market declined substantially from the levels reached in October and overnight securities lending from the System Open Market Account portfolio fell sharply. Heavy demand for safe instruments was also apparent in the Treasury bill market, where yields turned negative at times. During the intermeeting period, the Treasury announced that it would not roll over bills related to the Supplementary Financing Program in order to preserve flexibility in the conduct of debt management policy, and uncertainty about supply reportedly exacerbated poor liquidity conditions in the bill market. Despite the decline in spreads of agency and mortgage-backed repo rates over Treasury GC rates later in the period, strains in these markets remained evident, with bid-asked spreads and haircuts very elevated.
In contrast, conditions in the commercial paper (CP) market improved over the intermeeting period, likely as a reflection of recent measures taken in support of this market. Spreads on 30-day A1/P1 and asset-backed commercial paper (ABCP) continued to narrow after the Commercial Paper Funding Facility (CPFF) became operational on October 27, although spreads subsequently reversed a portion of the declines as maturities crossed over year-end. In contrast, spreads on commercial paper not eligible for purchase under the CPFF remained elevated. The dollar amounts of unsecured financial CP and ABCP outstanding rebounded from their October lows, though issuance into the CPFF more than accounted for this increase. Credit outstanding under the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility fell by more than half over the intermeeting period. The Money Market Investor Funding Facility program registered no activity.
As financial market conditions worsened over the intermeeting period, investors seemed to become more concerned about the likelihood of a deep and prolonged recession. In addition, the Treasury Department's announcement that funds from the Troubled Asset Relief Program would not be used to purchase securities backed by mortgage-related and other assets appeared to prompt negative price reactions in several financial markets. Stock prices of financial corporations fell considerably, while broad equity indexes declined, on net, amid high volatility. Yields on investment-grade bonds moved lower, but risk spreads on these instruments over comparable-maturity Treasury securities widened substantially as yields on Treasury securities fell more. Yields and risk spreads on speculative-grade bonds soared, and credit default swap spreads on speculative-grade, as well as investment-grade, corporate bonds widened further. Gross issuance of bonds by nonfinancial investment-grade companies continued at a solid pace, but issuance of speculative-grade bonds remained at zero. Issuance of leveraged syndicated loans was also extremely weak. Strains were evident in a number of other financial markets as well. The functioning of Treasury markets remained impaired, and premiums for the on-the-run ten-year nominal Treasury security rose from levels that were already elevated. The market for commercial mortgage-backed securities experienced a particularly pronounced selloff.
Reflecting investor concerns about the conditions of financial institutions, spreads on credit default swaps for U.S. banks widened sharply, and those for insurance companies remained elevated. To support market stability, the U.S. government on November 23 entered into an agreement with Citigroup to provide a package of capital, guarantees, and liquidity access. In other developments, banking organizations began to take advantage of the Federal Deposit Insurance Corporation's (FDIC) Temporary Liquidity Guarantee Program; eleven institutions issued bonds under the program.
In view of the tightening of credit conditions for consumers and small businesses, the Federal Reserve announced on November 25 the creation of the Term Asset-Backed Securities Loan Facility to support the markets for asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. The facility, developed jointly with the Treasury, was expected to be operational by February 2009, and discussions with market participants about operational details of this facility were ongoing.
The Federal Reserve also announced on November 25 that, to help reduce the cost and increase the availability of residential mortgage credit, it would initiate a program to purchase up to $100 billion in direct obligations of housing-related government-sponsored enterprises (GSEs) and up to $500 billion in MBS backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Agency debt spreads, which had widened early in the period, narrowed somewhat after the announcement. Subsequent purchases of agency debt by the Open Market Desk at the Federal Reserve Bank of New York led to a further reduction in agency spreads. Likely reflecting in part these developments, conditions in the primary residential mortgage market improved. The interest rate on 30-year fixed-rate conforming mortgages declined, which prompted a noticeable increase in mortgage refinancing.
M2 expanded at a considerably slower rate in November than October. Retail money funds contracted after a surge in October that reflected safe-haven inflows to Treasury-only funds. Small time deposits increased somewhat more slowly than in October, although the rate of expansion remained quite rapid as banks continued to bid aggressively for these deposits. Flows into demand deposits covered by the FDIC's new temporary guarantee program were significant and apparently reflected shifts out of savings accounts as well as redirection of funds by banks' customers away from other money market instruments. Currency continued its strong increase, apparently boosted by solid foreign demand for U.S. banknotes.