Staff Review of the Economic Situation
The information reviewed at the April 28-29 meeting indicated that the pace of decline in some components of final demand appeared to have slowed recently. Consumer spending firmed in the first quarter after dropping markedly during the second half of 2008. Housing activity remained depressed but seemed to have leveled off in February and March. In contrast, businesses cut production and employment substantially in recent months--likely reflecting, in part, inventory overhangs that persisted into the early part of the year--and fixed investment continued to contract. Headline and core consumer prices rose at a moderate pace over the first three months of the year.
Labor market conditions deteriorated further in March. Private nonfarm payroll employment registered its fifth consecutive large monthly decrease, with losses widespread across industries. Moreover, the average workweek of production and nonsupervisory workers on private payrolls ticked down in March from the low level recorded in January and February, and total hours worked for this group stayed below the fourth-quarter average. The civilian unemployment rate climbed to 8.5 percent, and the labor force participation rate edged down from its February level. The four-week moving average of initial claims for unemployment insurance remained elevated in April, and the number of individuals receiving unemployment benefits relative to the size of the labor force reached its highest level since 1982.
Industrial production fell substantially in March and for the first quarter as a whole, with cutbacks widespread across sectors, and manufacturing capacity utilization decreased to a very low level. First-quarter domestic production of light motor vehicles reached the lowest level in more than three decades as inventories of such vehicles, while low, remained high relative to sales. The output of high-technology products decreased in March and in the first quarter overall, with production of computers and semiconductors extending the downward trend that had begun in the second half of 2008. In contrast, the production of communications equipment edged up in the first quarter. The output of other consumer durables and business equipment stayed low, and broad indicators of near-term manufacturing activity suggested that factory output would contract over the next few months.
The available data suggested that real consumer spending rose moderately in the first quarter after having fallen in the second half of last year. Real spending on goods and services excluding motor vehicles fell in March but was up, on balance, for the first quarter as a whole. Real outlays on new and used motor vehicles expanded in the first quarter following six consecutive quarterly declines. Despite the upturn in consumer spending, the fundamentals for this sector remained weak: Wages and salaries dropped, house prices were markedly lower than a year ago, and, despite recent increases, equity prices were down substantially from their levels of 12 months earlier. As measured by the Reuters/University of Michigan survey, consumer sentiment strengthened a bit in early April, as households expressed somewhat more optimism about long-term economic conditions; however, even with this improvement, the measure was only slightly above the historical low for the series recorded last November.
The latest readings from the housing market suggested that the contraction in housing activity might have moderated over the first quarter. Single-family housing starts flattened out in February and March, and, after adjusting for activity outside of permit-issuing areas, the level of permits in March remained above the level of starts. The contraction in the multifamily sector also showed signs of slowing, as the drop in starts in the first quarter was well below the pace experienced during the fourth quarter of 2008. Recent data also indicated that housing demand might have stabilized. Sales of new single-family homes held steady in March after edging up in February, but the level of such sales remained low, leaving the supply of new homes relative to the pace of sales very high by historical standards. Existing home sales in March were slightly below the average pace for January and February. Most national indexes of house prices stayed on a downward trajectory. Lower mortgage rates and house prices contributed to an increase in housing affordability. Rates for conforming 30-year fixed-rate mortgages extended the significant decline that began late last year. Rates on jumbo loans came down as well, although the spread between the rates on jumbo and conforming loans was still wide and the market for private-label nonprime MBS remained impaired.
Real spending on equipment and software dropped markedly in the first quarter, with declines about as steep and widespread as in the fourth quarter of 2008. Orders and shipments of nondefense capital goods excluding aircraft fell in March, turning negative again after having been flat in February. The fundamental determinants of equipment and software investment stayed weak in the first quarter: Business output continued to drop sharply, and credit availability was still tight. In the April Senior Loan Officer Opinion Survey on Bank Lending Practices, the net percentages of respondents that reported they tightened their business lending policies over the previous three months, although continuing to be very elevated, edged down for the second consecutive survey. Real spending on nonresidential structures contracted in the first quarter. Despite the significant cuts in production in recent quarters, inventories remained sizable early in the year, although the overhang appeared to be less severe than in late 2008. Given the elevated level of inventories, firms continued their efforts to reduce their stocks.
The U.S. international trade deficit diminished in February to its lowest level since November 1999, as imports fell and exports rose a bit. Most major categories of exports increased, especially sales of consumer goods, and within that category, pharmaceuticals. Exports of capital goods rose despite a modest decrease in exports of aircraft, and exports of automotive products increased following a marked drop in January; in contrast, exports of services declined in February. All major categories of imports decreased. The fall in oil imports was driven by lower volumes as prices moved up slightly; prices of non-oil imports moved down, but falling volumes accounted for most of the decline in this category.
Economic conditions again worsened in the advanced foreign economies in the first quarter. Industrial production continued to drop through February, employment declined substantially, and retail sales were weak. However, indicators of developments late in the first quarter, particularly the purchasing managers indexes for all of the major advanced economies, increased, suggesting some moderation in the pace of contraction of economic activity going forward. The first-quarter data also offered a few tentative signs that the deceleration of economic activity in emerging markets might have started to abate. In particular, the growth of real gross domestic product (GDP) in China appeared to pick up on a quarterly basis following fiscal stimulus measures and steps to foster credit expansion.
In the United States, overall consumer prices increased over the first three months of 2009 after falling in the fourth quarter of 2008: Energy prices rebounded somewhat after their substantial late-year drop, and core prices picked up. In contrast, the producer price index for core intermediate materials fell, though at a noticeably slower pace than in late 2008. Indexes of commodity prices rose in March but stayed far below their year-earlier values. Near term inflation expectations increased in early April but did not appear to influence longer-term expectations, whose levels in April were still at the low end of the range seen over the past few years. Hourly earnings of production and nonsupervisory workers edged up in March.
Staff Review of the Financial Situation
The decision by the Federal Open Market Committee (FOMC) at the March meeting to leave the target range for the federal funds rate unchanged was widely anticipated and had little effect on short-term money markets. However, investors were apparently surprised by the Committee's announcement that it would increase significantly further the size of the Federal Reserve's balance sheet by purchasing up to $300 billion in Treasury securities and expanding purchases of agency MBS and agency debt. In addition, market participants reportedly interpreted the statement that the federal funds rate was likely to remain exceptionally low "for an extended period" as stronger than the phrase "for some time" in the previous statement. Rates on Eurodollar futures contracts and yields on Treasury and agency securities fell considerably in response to the statement. The initial drop in the expected path for the federal funds rate was reversed over subsequent weeks, however, likely in response to the somewhat better economic outlook. Similarly, a portion of the substantial declines in yields on nominal Treasury coupon securities that followed the FOMC announcement was subsequently unwound amid the improved economic outlook, an easing of concern about financial institutions, and perhaps some reversal of flight-to-quality flows. Yields on inflation-indexed Treasury securities fell a bit more than those on their nominal counterparts, which decreased modestly, on net, over the period. As a result, inflation compensation rose at shorter horizons but changed little at longer horizons. Poor liquidity in the market for Treasury inflation-protected securities continued to make these readings difficult to interpret.
Conditions in short-term funding markets improved somewhat over the intermeeting period. In unsecured bank funding markets, spreads of dollar London interbank offered rates (Libor) over comparable-maturity overnight index swap (OIS) rates edged down, although Libor fixings beyond the one-month maturity stayed elevated. Spreads on A2/P2-rated commercial paper and AA-rated asset backed commercial paper narrowed a bit, on net, staying at the low end of their respective ranges over the past year. Functioning in the repurchase agreement (repo) market showed additional improvement, as bid-asked spreads and "haircuts" on most collateral either narrowed or held steady, although repo volumes were still low. Consistent with modestly better conditions in the term repo market, all seven auctions under the Term Securities Lending Facility were undersubscribed over the intermeeting period, including two auctions that garnered no bids.
Trading conditions in the secondary market for nominal Treasury securities also showed some signs of improvement. Premiums paid for on-the-run Treasury securities fell, and average bid asked spreads for Treasury notes were relatively stable near their pre-crisis levels. Still, daily trading volumes for Treasury securities remained low.
Broad stock price indexes rose significantly, reportedly buoyed by announcements of policy measures to enhance credit markets and clean up banks' balance sheets and perhaps by some reduction in concerns about the economic outlook. Financial stocks outperformed broader markets, boosted by relatively favorable first-quarter earnings reports from a few major firms. The spread between the forward trend earnings-price ratio for S&P 500 firms and an estimate of the real long-run Treasury yield--a rough gauge of the equity risk premium--narrowed during the intermeeting period but was still very high by historical standards. Option-implied volatility on the S&P 500 index decreased but stayed well above historical norms.
On net, yields on lower-rated investment-grade and speculative-grade corporate bonds dropped, resulting in a narrowing of spreads in yields on such bonds over those on comparable-maturity Treasury securities. Even so, corporate bond spreads remained extremely high by historical standards.
Indicators of functioning in the corporate bond market--such as bid-asked spreads estimated by the staff--suggested that conditions in the speculative-grade segment of the market had become less strained since last autumn. Corresponding measures for investment-grade bonds hovered at moderately elevated levels. The leveraged loan market showed some improvement over the past few months, with the average bid-asked spread narrowing and the average bid price moving up from a very depressed level. The basis between an index of credit default swap spreads and measures of investment-grade corporate spreads--a rough proxy for unexploited arbitrage opportunities in the corporate credit market--stayed at high levels, reportedly reflecting an ongoing lack of financing capacity at major financial institutions. No issuance of commercial MBS occurred over the intermeeting period.
The debt of the domestic private nonfinancial sector appeared to have contracted in the first quarter at about the same pace as in the fourth quarter of 2008. Activity in the mortgage market reflected mainly refinancing, and staff estimates indicated that residential mortgage debt contracted again in the first quarter, depressed by the very low pace of home sales, falling house prices, and write-downs of nonperforming loans. Consumer credit was essentially flat in January and February. Expansion of nonfinancial business debt was tepid, as robust bond issuance was partly offset by declines in commercial paper and bank loans. Federal debt rose briskly in the first quarter.
M2 expanded rapidly in March. A strong increase in liquid deposits, the largest component of M2, likely reflected further reallocations by households toward safer assets. Retail money market mutual funds and small time deposits contracted modestly. Currency growth was apparently bolstered by elevated foreign demand.
Commercial bank credit contracted in March and was estimated to have dropped again in April. The decline in bank credit in March was due importantly to a decrease in loans to businesses that reflected, in part, paydowns with the proceeds of bond issuance. Commercial real estate loans also fell. Bank lending to households was weak, although credit extended under revolving home equity lines of credit again expanded robustly. Residential mortgage loans on banks' books fell, on balance, in March and the first part of April; banks reportedly sold a considerable amount of single-family mortgages to the government-sponsored enterprises. Consumer loans held by banks also shrank, amid heavy securitization. The Senior Loan Officer Opinion Survey conducted in April indicated that banks continued to tighten their credit standards and terms on all major loan categories over the previous three months.
Stock markets around the world rose substantially over the intermeeting period amid somewhat better sentiment regarding economic prospects, reports of better-than-expected performance from some financial firms in the United States and Europe, and continued support from monetary policies. Pressures in bank funding markets seemed to ease over the period: Spreads between both euro and sterling Libor and their respective OIS rates narrowed significantly, and financial conditions in most emerging market economies improved. The dollar depreciated against the other major currencies in an environment of seemingly increased investor appetite for risk.
During the intermeeting period, foreign authorities took additional steps to address the weaknesses in their economies and financial systems. The European Central Bank and the Bank of Canada, along with several other central banks in both the advanced and emerging market economies, cut policy rates, while the Bank of England and the Bank of Japan continued their asset purchases to provide further monetary stimulus. Several governments, including Japan and Taiwan, announced new fiscal stimulus packages, and a number of European countries took additional measures to support their banking sectors.