Weekly Policy Update – Fed Adopts More Aggressive Measures to Facilitate an Economic Recovery
The Federal Reserve held the overnight federal funds rate unchanged at 0%-0.25%, as expected. The expansion of existing programs and the decision to purchase long-dated Treasury securities were surprise elements of the announcement. The Fed’s balance sheet declined to $1.85 trillion during the week ended February 11, 2009 and has since increased to $2.07 trillion for the week ended March 16. The Fed’s policy statement noted that the Fed would purchase an additional $750 billion of agency mortgage-backed securities, increase the purchase of agency debt by $100 billion, and buy $300 billion of longer-term Treasury securities, which amounts to an expansion of the balance sheet by $1.15 trillion. The net impact could be smaller as some programs could possibly shrink when the terms of the programs become less attractive or unnecessary.
Equity and bond markets responded favorably after the policy announcement but the dollar lost ground on March 18 and March 19 (see comment below) but it has erased a part of the loss today. The 10-year Treasury note yield declined to 2.51% after the FOMC policy statement was published from 3.00% earlier in the day. As of this writing, it was trading at 2.62%. The objective of purchasing Treasury securities is to bring about a reduction in long rates with the expectation that these lower rates would reduce interest rates on private-sector securities such as mortgage rates. We will be tracking these borrowing rates closely to assess the impact of the Fed’s actions. The 30-year mortgage rate was 4.98% as of the week ended March 20 and Moody’s Baa corporate bond yield was 8.39% on March 18, down from 8.62% on March 17 (see chart 2).
The Fed’s quantitative easing policy is designed to not only influence the quantity and price of credit, but also the sectors receiving credit (e.g., commercial paper market, mortgage-backed securities, asset-backed securities). Like conventional quantitative easing policy whereby the central bank prints money to buy government securities (the latest decision of the FOMC to purchase long-dated Treasuries accomplishes this aspect), the Fed’s earlier actions also include programs that have already increased the size of its balance sheet through arrangements to buy/support private credit extensions, some of which were expanded (broadened eligibility of assets under TALF and increased quantity of purchases of mortgage backed securities and agency debt) on March 18.
The Fed noted the economy continues to contract and concluded that “although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.” With regard to inflation, the FOMC indicated that there is “some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.” Essentially, the Fed’s view about inflation is unchanged from the January policy statement.
The Fed’s bold moves are directed toward the prevention of a deflationary spiral in the U.S. economy. Assuming that the Fed is successful in preventing this deflationary spiral, a couple of years from now it might face the risk of an inflationary spiral. The main issues are timing and magnitude of unwinding the extraordinary growth of the balance sheet when there is self-sustaining economic growth and before the seeds of inflation are firmly planted.
The Dollar’s Plunge – A Historical Side
A historical tour to place the dollar’s plunge on March 19 in perspective is the extra zing for the last day of a tumultuous week. The dollar plunged after the Fed announced its aggressive move on March 18 to expand its balance sheet by a stunning $1.15 trillion to alleviate economic conditions.
The dollar fell 4.52% to 0.7283 euros per dollar on March 19 -- the largest daily drop in the exchange rate since the birth of the euro in 1999 (see chart 4).
The fortunes of the dollar were unfavorable vis-à-vis the Japanese yen also. The greenback declined 4.31% March 19 to 93.85 yen per dollar, a comparable drop occurred on October 6, 2008 (-4.25%). The largest depreciation of the dollar vs. the yen since 1971 has been a 5.47% drop on October 7, 1998 (see chart 5).
The trade weighted dollar fell 2.68% and 1.74% on March 18 and March 19 (not shown in chart 6), respectively. The history of the trade weighted dollar (1973 – March 13, 2009) is shown in chart 6. The largest daily decline of the trade weighted dollar (-2.91%) was on October 29, 2008 which was also when the Fed lowered the federal funds rate 50 bps to 1.00% (see chart 6).
There are a few outliers in the daily downward movements of the trade weighted value of the dollar that are noteworthy because they coincide with important economic/financial market developments (see table 1). Declines in the trade weighted value of the dollar in excess of 2.0% in a single trading session are listed in table 1, excluding the decline on March 19, 2009.
What is the message from this long-winded historical discussion? Markets overshoot, particularly when unexpected financial and economic events transpire and they draw out an exaggerated response. This does not imply a discounting of the enormity of the crisis at hand or the reason for the Fed’s forceful move but it highlights the need to place events in a historical context. Arguments against dollar bears are gathering steam. First, as of this writing, the dollar has moved up vis-à-vis the euro (0.73 euros per dollar), vis-à-vis the yen (95 yen per dollar) and the trade weighted dollar was at 83.82 (+0.9% from yesterday). Second and more importantly, the current account deficit as a percent of GDP has dropped to 3.47% in the fourth quarter of 2008, the lowest in seven years! The current deficit is a reflection of the saving shortfall in the U.S. economy. As there are meaningful indications that this serious shortcoming is on the way to be fixed, albeit over a period of time, the severity of the risk attached to the dollar may have to be scaled back.
The underlying trend of the trade weighted dollar suggests that a significant erosion of the trade weighted dollar in the near term would require an extraordinary trigger.
