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December 16, 2008 Fed Slashes Rate to 0-to-25 bps Range; Historic Use of Fed Balance Sheet to Ease
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The Federal Reserve has every reason to ease aggressively and it certainly
did. The FOMC announced at 2:15 PM today that it is taking the benchmark fed
funds rate target down from 1.0% to a record-low range of 0-to-25 basis
points. It is also using “all available tools to promote the
resumption of sustainable economic growth and to preserve price
stability.” The easing is open-ended; the Fed expects “that
weak economic conditions are likely to warrant exceptionally low levels of the
federal funds rate for some time.” They can’t get more
aggressive than this. For the first time in its 95-year history, the Fed
“over the next few quarters…will purchase large quantities of
agency debt and mortgage-backed securities to provide support to the mortgage
and housing markets…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 Board also reduced the discount rate by 75 basis
points to 0.5%. The Committee was unanimous in all of these decisions.
This is an historic move and it will go down in the annals of Fed history as
the most aggressive attempt ever to reverse a deep recession, prevent deflation
and spur financial-market re-normalization. While running out of basis-point
ammo, the Fed will conduct very aggressive ‘quantitative’
easing—buying GSE debt, MBS and possibly longer-term Treasury bonds in
the open market, driving mortgage rates and government bond yields lower and
providing additional credit for households, homeowners and small business.
The Fed is set to take extraordinary steps to boost the quantity of money in
the world’s largest economy. The Fed is using its own balance sheet as a
tool of monetary policy.
This announcement is putting further downward pressure on the U.S. dollar
against the yen and other major currencies. Interest rates fell immediately and
sharply on the news and stocks rallied.
While the Fed slashed the benchmark overnight rate to a range of 0-to-25
basis points, the effective funds rate has been trading more than 60 basis
points below the former 1.0% target in recent weeks. Banks are holding excess
reserves, reducing the demand for interbank overnight lending. The flow of
private and public funds, domestically and internationally, into the safe haven
of Treasuries had already driven interest rates down to incredibly low
levels—a mere 0-to-3 basis points on one- and three-month bills and 2.54%
on 10-year bonds, despite the rise in Treasury issuance. Immediately following
the press release, the 10-year Treasury yield was down to roughly 2.37%.
The Fed has already been easing aggressively for more than a year. The
monetary base has risen over 70% y/y, but with a huge plunge in the money
multiplier (M1 divided by the monetary base) owing to very weak lending, M1
growth has increased by a far more moderate 11.5%. Moreover, the velocity of
money (GDP divided by M1) has plummeted as businesses and consumers hoard cash
or pay down debt.
As the Fed realizes publicly, the negative feedback loop in the U.S. and
elsewhere continues to drive economic activity lower than expected even a few
weeks ago. The latest evidence of this is the further plunge to a record low
level of U.S. housing starts reported today. And while interbank lending rates
have fallen meaningfully, corporate yield spreads continue to widen as risk
premiums in the bond market rise reflecting growing default risk. Around the
world, the recession is deepening and in Canada, housing activity is now
declining nationally and manufacturing shipments have fallen for three
consecutive months as the terms of trade turn further against us. Earlier
today, the euro came under pressure after the preliminary purchasing managers
indexes for the euro zone’s manufacturing and services sectors fell to
record lows, signaling a deepening of the recession in the 15-nation
region.
Emerging economies are also weakening sharply as China’s economy hits
a wall. Unemployment is rising as Chinese exports fall and laid-off factory
workers in southern China have staged protests that had to be contained by riot
police. As Chinese growth falls, possibly well below 8% next year, unemployment
will rise sharply. The new Obama administration will probably encourage China
to revalue its currency and growing protectionism in the U.S. and Europe is a
risk. It was the Smoot-Hawley Tariff Act, signed in 1930, that penalized
imports into the U.S., which set off a worldwide round of retaliatory tariff
increases in 1931, making a dire economic situation even worse.
Continued tight credit conditions are evidenced by the growing demand for
Federal Reserve funding of commercial paper, commercial-real-estate backed
bonds, discount window loans to commercial banks and primary dealers, and
support of money market mutual funds. This, along with the Fed’s term
auction credit and currency swap arrangements with foreign central banks, has
already more than doubled the size of the Fed’s balance sheet to a record
$2.3 trillion. The Fed is particularly concerned about the period through the
end of January, as yearend window dressing and tax-loss selling puts downward
pressure on many markets.
As well, the risk of deflation also increases as the U.S. CPI has fallen
sharply for two consecutive months (owing to the plunge in energy prices),
pulling down the y/y headline inflation rate to 1.1% from 1.9% in October.
November’s inflation rate, released today, decreased 1.7%, the most in
any single month since the series started in 1947. Inflation is now at the
43-year low hit during 1986 and 2002. Core inflation has also fallen and is
likely headed below the 2% y/y rate in November. Headline inflation will likely
move into negative territory next year, with core inflation falling to a mere
1%. Nothing worries Chairman Bernanke more than deflation. You can count on the
Fed dropping more and more money into the system to mitigate this risk.
Investor confidence is further damaged by the eye-popping (estimated) $50
billion Madoff hedge fund fraud, the repercussions of which are still
uncertain. Among other banks and wealthy investors, HSBC, Europe’s
largest bank and headquartered in London, said it has combined exposure of
about $1 billion. While stock market volatility has fallen a bit in recent
days, financial stocks in Canada continue to fall as U.S. financial stocks
rally. Canadian banks (RY, TD, BMO and CM) have all had equity offerings in
recent weeks to boost Tier 1 capital ratios, even though they are well above
ratios for most banks in the U.S.
Another negative factor for the economy is the dramatic decline in auto
sales that has burned through the cash balances of Chrysler and GM. (According
to Market Watch, the market cap of GM is now lower than it was in 1927.)
The U.S. Senate last week turned down the House bill for auto bridge-financing.
Automakers will likely get last-minute stopgap funding from the
Treasury’s TARP. Nevertheless, pre-packaged bankruptcy for GM (and
Chrysler) might then occur in early-2009 unless the Obama government comes to
the rescue or a car czar can successful twist arms to elicit real negotiation
and sacrifice on the part of the union, carmakers, dealers and suppliers. In
the meantime, people are shunning car purchases, which in itself worsen the
economic situation in both Canada and the U.S.
A new study suggests that Ontario could lose more than a half-million jobs
if the Detroit Three were to go out of business. Ottawa and Ontario last week
announced a $3.4 billion aid package designed to complement the U.S. bailout.
The Canadian government is in a particularly difficult situation given that the
U.S. actions (or inactions) will generally determine how Ontario’s car
sector will fare. There is no point in Canada offering immediate bailout money
if a U.S. refusal forces them into bankruptcy. Mexico is now the top producer
of American cars, taking that spot from Ontario as the industry here contracts
despite the relatively high productivity of Canadian auto assembly plants.
Suppliers in Ontario also feel the pinch as they respond to both decreased
demand and delayed payments by GM with large cuts in production. The
uncertainty is spilling into other sectors as consumers cut back spending on
all nonessentials. The prospect of a collapse in the auto industry is weighing
on both the U.S. and Canadian dollars.
In addition to the auto concerns, Canada is experiencing its own financial
pressures that include the request for federal backstop for the troubled ABCP
deal, the collapse of the BCE deal, deteriorating household balance sheets,
rapidly weakening real estate markets and the dramatic slide in the value of
pensions. The plunge in Canadian stock prices has contributed to a marked
decline in household net worth directly and through the reduced value of life
insurance assets, mutual funds, variable annuities and pension fund
balances.
Bottom Line: The Fed joins the Bank of Canada in responding
aggressively to the deepening recession and increasing prospect of deflation.
Very large fiscal stimulus is also coming in both countries in the first
quarter of next year; it will be especially large in the U.S. and will likely
extend into 2010 and possibly beyond. With every layoff announcement and stock
market decline, consumer confidence drops. It will take a mighty effort by
central banks and government authorities to drag the global economy out of this
ditch, but with the stimulus we are likely to see in coming months, the economy
will hopefully bottom around midyear ‘09 followed by a sluggish recovery
in the second half and moderate growth in 2010.
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