Down Another Seventy-Five
On March 18, 2008, the Federal Open Market Committee (FOMC) voted to lower its target for the federal funds rate by 75 basis points to 2.25 percent. In supporting the move, the committee noted that "Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters." Despite these concerns, the committee noted that "Inflation has been elevated, and some indicators of inflation expectations have risen." Concerns about inflation were behind the two dissents recorded at the meeting. Those dissenting, Richard W. Fisher of Dallas and Charles I. Plosser of Philadelphia, "preferred less aggressive action at this meeting."
Since September 2007, the FOMC has cut its funds rate target 300 basis points. While the speed of the cuts has certainly been dramatic, it is useful to recognize that the overall quantity cut is not unprecedented. Just before the beginning of the 2001 recession, the FOMC began to cut rates and by the end of six months, it had cut them 275 basis points. From January 2001 to December 2001, rates were cut a whopping 475 basis points.
One indicator of the financial pressure mentioned in the committee's statement is the spread between the three-month LIBOR, the rate at which banks lend to each other in the wholesale London money market, and the rate on the on the comparable 90-day Treasury security, the rate at which the U.S. government borrows. A look at this spread shows that stress in financial markets has been quite elevated since July 2007. More alarming is that the spread is higher now than it was during the Russian default crisis or the Asian crisis. To address this stress, the Federal Reserve has not only cut the funds rate, but it has also created two new lending programs, the Term Auction Facility (TAF) and the Term Security Lending Facility (TSLF).
The TAF was introduced in December to address "elevated pressures in short-term funding markets." The TAF provides another means by which the Federal Reserve can inject liquidity into the banking system. Historically, the Fed did this with loans to financial institutions, but concern had arisen that such loans did not always adequately accommodate periods of financial stress. One reason for this shortcoming was thought to be financial institutions' possible reluctance to borrow through the discount window for fear it would signal financial weakness. The TAF was instituted to overcome this stigma effect. In addition, it provides a 28-day loan rather than the overnight loans that were typically offered at the discount window.
In its March 11 announcement, the Fed affirmed that the TSLF facility was instituted "to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally." It provides increased liquidity by dealing directly with a group of primary dealers (including some major nondepository investment banks, which do not have direct access through the TAF). It also accepts a wider range of assets as collateral than the TAF. In particular, the program allows these institutions to borrow Treasury securities backed by the pledge of Aaa-rated mortgaged-backed securities. These securities, however, were already allowed as collateral through the discount window. Like the TAF, the TSLF also provides loans with 28-day terms.
Besides short-term financial stresses, officials are concerned that longer-term credit is becoming harder to secure. The fear is that shorter-term liquidity issues can become longer-term credit problems. Should credit issues gain a hold, they cannot be attacked through the short-term funding arrangements offered by the Fed. Instead, broad cuts in the funds rate, as well as clear communication about the rate's future path, will be needed to attack longer-term credit issues.
One measure of these longer-term credit problems is the spread between yields on Aaa-rated securities, the highest-quality corporate bond, and the comparable 10-year Treasury note. This measure of credit risks is clearly elevated but does remain below its levels during the 2001 recession. More alarming to some is that since July, it has increased more than 125 basis points - a six-month movement beyond anything witnessed in recent history.
While acknowledging the risks to inflation, the committee indicated that these risks were outweighed by risks to the real economy by stating, "However, downside risks to growth remain." The markets interpreted this statement as evidence that more rate cuts are almost certain to occur. Over 90 percent of participants in the fed funds futures market expect at least a 25 basis point cut at or before the next scheduled meeting, April 29-30. Nearly 60 percent of participants are betting on a cut of at least 50 basis points.
April Meeting Probabilities
Note: Probabilities are calculated using trading-day closing prices from options on federal funds futures that trade on the Chicago Board of Trade.
Source: Chicago Borad of trade and Bloomberg Financial Services.
While fed funds futures provide a sense of where the funds rate is expected to head in the immediate future, the one-year Overnight Index Swap rate (OIS) provides a measure of what the funds rate is expected to average over the next year. A look at this rate suggests that the funds rate will average 50 basis points lower than the current funds rate, and thus that by next year, more than another 50 basis points will be cut.