December 16 FOMC Meeting: The Credit Machine Is the Primary Focus
The FOMC announced a target range for the federal funds rate of 0 to 0.25% at the close of the meeting today. The discount rate is now 50 bps, a reduction of 75 bps. The policy announcement also noted that the Fed will pay 25 bps on required and excess reserves. These were the major changes of monetary policy announced today
The effective federal funds rate has ranged between 11bps and 18bps since December 5, 2008 (see chart 1). Also, the daily effective federal funds rate has been trading below the target rate since September 19, excluding three occasions (September 30, October 7 and 8). Today’s action has moved the Fed into the arena where its actions will now directly influence interest rates instead of the Fed changing the federal funds rate to influence all other interest rates.
The policy statement notes: “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”[Emphasis added.]. The Fed is focused on fixing the broken credit machine and reviving economic activity and it has made it abundantly clear that the federal funds rate will not be raised in the near term. The key here is the implied duration of an unchanged federal funds rate which should allow bankers to recapitalize and go about the businesses of lending. In order to reach the goal of reviving the economy, the options it plans to employ are summarized in the latter part of the policy statement.
“The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity”
There are four options that the Fed has outlined in the above excerpt of the policy statement, which it will employ to lift economic growth. First, the reiteration that the Fed will buy large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets and in “quantities as needed” should drive down mortgage rates and raise purchases of homes and allow refinancing of existing mortgages (which is not part of the program now but could be included in the weeks ahead). This program was originally announced on November 25, 2008. According to the November announcement, purchases of $100 billion in GSE direct obligations and $500 billion of mortgage backed securities backed by GSEs will be undertaken. It is entirely conceivable it could exceed this amount. The 30-year fixed rate mortgage was 5.47% as of the week ended December 12, 2008, down from 6.20% during the week ended November 7, 2008 (see chart 2). Additional declines in mortgage rates should be expected. There are discussions about targeting the 30-year mortgage rate at 4.50%. The benefit of lower mortgage rates is that it would establish more stability in the housing market and clear inventories of unsold homes. In other words, the essence of this strategy is to get the housing market out of the current predicament it has persisted in for several months.
Second, the Fed policy statement indicated that “the Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.” The necessity and viability of this option is unclear. The 10-year Treasury note history starts in January 1953. A good proxy is the long-term Treasury composite rate (see chart 3) which dates back to 1925. The lowest yield was 1.98% in July and October of 1948.
Fast-forwarding to recent history, the 10-year Treasury note yield is at 2.25% as of this writing (see chart 4). It appears the benefit of targeting the mortgage rate is greater than fixing Treasury yields.
Third, “early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.” This program was also announced on November 25, 2008. The Term Asset-Backed Securities Loan Facility (TALF) is a joint program with the Treasury. The program that will involve the Federal Reserve Bank of New York lending up to $200 billion to holders of AAA-rated asset backed securities “backed by newly and recently originated consumer and small business loans.” The U.S. Treasury Department, under the Emergency Economic Stabilization Act of 2008, will absorb $20 billion of losses and provide credit protection to the Federal Reserve Bank of New York for these non-recourse loans. The loans will involve a haircut based on the asset class and there is fee for participation. This new program is designed to address problems in the auto, student, credit card sectors, and loans guaranteed by the Small Business Administration. Loans to consumers have become scarce because securitization of consumer loans has come to a standstill. Extensions of loans to holders of these securities will enable the credit machine to resume working once again and enhance the availability of credit for households.
Fourth, “the Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.” The balance sheet of the Fed has grown to $2.26 trillion as of December 10, 2008 from $896 billion as of June 2008. The Fed has been a creative lender of last resort in the current turmoil. It has not revealed other cards it can play with, as yet.
A narrowing of credit market spreads will be one of the early signals that the underlying conditions in financial markets have turned around for the better. The spread between the 3-month Libor and 3-month Treasury bill is 184 bps as of this writing, which still exceeds the level seen prior to the shutdown of Lehman Brothers on September 15, 2008 (see chart 6) but below the extraordinary highs following the collapse of Lehman Brothers.
At the more risky end, the spread between the Merrill Lynch junk bond yield and the 10-year Treasury note yield continues to scale new heights (see chart 7).
In addition to improving conditions in credit markets, housing market indicators will guide if the economic conditions have turned the corner. At the present time, although sales of existing single-family homes have fallen sharply, the level of sales is now moving sideways (see chart 8). Sales of new single-family homes, however, continue to trend down.
Inventories of existing homes have declined slightly from their elevated level (see chart 9) but inventories of unsold new homes show a more worrisome situation (see chart 10). Reports of home sales in November will be published on December 23.
Revival of Economic Growth Not Inflation is at the Top of the Agenda
The Consumer Price Index (CPI) fell 1.7% in November following a 1.0% drop in October. On a year-to-year basis, the CPI has fallen 1.1% vs. a 4.1% increase in all of 2007 and a cycle high of 5.6% year-to-year increase in July 2008.
In November 2008, the seasonally unadjusted CPI, which goes back to 1921, fell 1.9%, the largest drop since the 1930s (see chart 12).
Lower energy prices, particularly gasoline, accounted for the sharp drop in the overall CPI. The 17.0% plunge in the energy price index reflects a 29.5% drop in gasoline prices, a 5.2% drop in natural gas prices, and a 14.6% decline in heating oil prices. Excluding energy, the CPI was unchanged in November. During the twelve months ended November, the CPI excluding energy moved up 2.6%, a noteworthy deceleration from a cycle high of 3.09% in August 2008.
Food prices advanced 0.2% in November compared with a 0.3% in October. The food price index posted sharp increases in the June-August period with monthly gains ranging between 0.6% and 0.9%. The food price index has moved up 6.05% in November from a year ago. It appears that the change in the food price index peaked in October 2008 (6.29% yoy increase).
Excluding food and energy, the core CPI held steady in November, following a 0.1% drop in October. During the three months ended November, the core CPI has risen at an annual rate of 0.4% and it has moved up 2.0% from a year ago. The cycle high for the core CPI was a 2.93% year-to-year increase in September 2006. The index for shelter rose 0.2% in November, inclusive of a 0.3% gain in rent and owners’ equivalent rent. The car price index for new and used vehicles dropped 0.9% in November after a 0.7% drop in October. Airfares fell 4.0% in November, marking the third consecutive monthly drop, but airfares are up 4.0% from a year ago. Clothing prices advanced 0.3%, medical care prices moved up 0.2%, education costs moved up 0.2%, and recreation prices held steady in November. The main focus of Fed policy is on reviving economic growth, while inflation is irrelevant given the weakness of the economy.
Construction of New Homes Establishes New Record Low
Home builders remain reluctant to break new ground. Housing starts fell 18.9% in November to an annual rate of 625,000, the lowest on record since record keeping for this series began in 1959 (see chart 14).
Construction of new single-family homes fell 16.95% to an annual rate of 441,000, also a new record (see chart 15). On a year-to-year basis, single-family housing starts were down 50% in November.
Housing starts are down over 70% from their peak in January 2006 (see table 2). This is the largest drop from the peak of home construction in each business cycle since 1960.
Starts dropped in all four regions of the country with the Northeast (-34.6%) posting the largest decline, followed by the Midwest (-23.1%), West (-16.8%), and the South (-15.6%). Permit extensions for construction of new homes fell 15.6% in November to an annual rate of 616,000 – a new record low. Permits for construction of new single-family homes fell 12.3% to 412,000, the second lowest on record after the 401,000 reading of October 1981. On a regional basis, permits issued dropped in all four regions of the country. Stability of the housing market is not here yet.
