Part 1: Overview: Monetary Policy and the Economic Outlook

The U.S. economy weakened markedly in the second half of 2008 as the turmoil in financial markets intensified, credit conditions tightened further, and asset values continued to slump. Conditions in the labor market worsened significantly after early autumn, and nearly all major sectors of the economy registered steep declines in activity late last year. Meanwhile, inflation pressures diminished appreciably as prices of energy and other commodities dropped sharply, the margin of resource slack in the economy widened, and the foreign exchange value of the dollar strengthened.

The second half of 2008 saw an intensification of the financial and economic strains that had initially been triggered by the end of the housing boom in the United States and other countries and the associated problems in mortgage markets. The ensuing turmoil in global credit markets affected asset values, credit conditions, and business and consumer confidence around the world. Over the summer, a weakening U.S. economy and continued financial turbulence led to a broad loss of confidence in the financial sector. In September, the government-sponsored enterprises Fannie Mae and Freddie Mac were placed into conservatorship by their regulator, and Lehman Brothers Holdings filed for bankruptcy. The insurance company American International Group, Inc., or AIG, also came under severe pressure, and the Federal Reserve, with the full support of the Treasury, agreed to provide substantial liquidity to the company. In addition, a number of other financial institutions failed or were acquired by competitors. As a result of the Lehman Brothers bankruptcy, a prominent money market mutual fund suffered capital losses, which prompted investors to withdraw large amounts from such funds. The resulting massive outflows undermined the stability of short-term funding markets, particularly the commercial paper market, upon which corporations rely heavily to meet their short-term borrowing needs. Against this backdrop, investors pulled back broadly from risk-taking in September and October, liquidity in short-term funding markets vanished for a time, and prices plunged across asset classes. Securitization markets, with the exception of those for government-supported mortgages, essentially shut down.

Reflecting in part the adverse developments in financial markets, economic activity dropped sharply in late 2008 and has continued to contract so far in 2009. In the labor market, the pace of job losses quickened considerably beginning last autumn, the unemployment rate has risen to its highest level since the early 1990s, and other measures of labor market conditions--for example, the number of persons working part time because full-time jobs are not available--have worsened noticeably. The deteriorating job market, along with the sizable losses of equity and housing wealth and the tightening of credit conditions, has depressed consumer sentiment and spending; these factors have also contributed to the continued steep decline in housing activity. In addition, businesses have instituted widespread cutbacks in capital spending in response to the weakening outlook for sales and production as well as the difficult credit environment. And in contrast to the first half of the year--when robust demand for U.S. exports provided some offset to the softness in domestic demand--exports slumped in the second half as economic activity abroad fell. In all, real gross domestic product (GDP) in the United States declined slightly in the third quarter of 2008 and is currently estimated by the Bureau of Economic Analysis to have dropped at an annual rate of 3-3/4 percent in the fourth quarter; real GDP seems headed for another considerable decrease in the first quarter of 2009.

The downturn in sales and production, along with steep declines in the prices of energy and other commodities and a strengthening in the exchange value of the dollar, has contributed to a substantial lessening of inflation pressures in the past several months. Indeed, overall inflation, as measured by the price index for personal consumption expenditures, turned negative in the fourth quarter of 2008; over the first three quarters of the year, overall inflation had averaged nearly 4-1/2 percent at an annual rate, largely because of sharp increases in food and energy prices. Core inflation--which excludes the direct effects of movements in food and energy prices--also slowed significantly late last year and entered 2009 at a subdued pace. Mirroring the drop in headline inflation, survey measures of near-term inflation expectations have fallen to very low levels in recent months, while the latest readings on longer-term inflation expectations are similar to those in 2007 and early 2008.

The Federal Reserve has responded forcefully to the crisis since its emergence in the summer of 2007. By the middle of last year, the Federal Open Market Committee (FOMC) had lowered the federal funds rate 325 basis points.¹ And as indications of economic weakness proliferated and the financial turbulence intensified in the second half, the FOMC continued to ease monetary policy aggressively; at its December meeting, the Committee established a target range for the federal funds rate of 0 to 1/4 percent and indicated that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

In addition, the Federal Reserve took a number of measures during the second half of 2008 to shore up financial markets and support the flow of credit to businesses and households. (See the appendix for descriptions of these programs.) In response to intensified stresses in dollar funding markets, the Federal Reserve announced extensions of its Term Auction Facility and significantly expanded its network of liquidity swap lines with foreign central banks. To support the functioning of the commercial paper market in the aftermath of the Lehman Brothers bankruptcy, the Federal Reserve established the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility in September as well as the Commercial Paper Funding Facility and Money Market Investor Funding Facility in October. In an effort to restart certain securitization markets and support extensions of credit to consumers, the Federal Reserve in November announced the Term Asset-Backed Securities Loan Facility, which is scheduled to begin operation in coming weeks. To support the mortgage and housing markets and the economy more broadly and to encourage better functioning in the market for agency securities, the Federal Reserve announced programs in November to purchase agency-guaranteed mortgage-backed securities and agency debt. These initiatives have resulted in a notable expansion of the Federal Reserve's balance sheet, and the FOMC has indicated that it expects the size of the balance sheet to remain at a high level for some time as a result of open market operations and other measures to support financial markets and to provide additional stimulus to the economy in an environment of very low short-term interest rates.

Other U.S. government entities and foreign governments also implemented a variety of policy measures in response to the intensification of financial strains over the course of the fall and winter. The Treasury announced a temporary guarantee of the share prices of money market mutual funds and, beginning in October, used authority granted under the Emergency Economic Stabilization Act to purchase preferred shares in a large number of depository institutions. That same month, the Federal Deposit Insurance Corporation (FDIC) introduced a Temporary Liquidity Guarantee Program under which it offers guarantees for selected senior unsecured obligations of participating insured depository institutions and many of their parent holding companies as well as for all balances in non-interest-bearing transaction deposit accounts at participating insured depository institutions. In November, Citigroup came under significant financial pressure. In response, the FDIC, the Treasury, and the Federal Reserve provided a package of loans and guarantees to bolster Citigroup's financial condition; a similar package was arranged for Bank of America in January. Since October, governments in many advanced economies have announced support plans for their banking systems. These programs have included large-scale capital injections, expansions of deposit insurance, and guarantees of some forms of bank debt.

The measures taken by the Federal Reserve, other U.S. government entities, and foreign governments have helped restore a degree of stability to some financial markets. In particular, strains in short-term funding markets have eased noticeably since the fall, some corporate risk spreads have declined modestly, and measures of volatility have generally retreated. Nevertheless, significant stress persists in most markets, and financial institutions remain under considerable pressure; as a result, the flow of credit to households and businesses continues to be impaired.

In conjunction with the January 2009 FOMC meeting, the members of the Board of Governors of the Federal Reserve System and presidents of the Federal Reserve Banks, all of whom participate in FOMC meetings, provided projections for economic growth, unemployment, and inflation; these projections are presented in part 4 of this report. Given the strength of the forces weighing on the economy, FOMC participants viewed the outlook as having weakened significantly in recent months. Participants generally expected economic activity to contract sharply in the near term and then to move onto a path of gradual recovery, bolstered by monetary easing, government efforts to stabilize financial markets, and fiscal stimulus. Participants expected total and core inflation to be lower in 2009 than over the four quarters of 2008, in large measure because of the recent declines in commodity prices and rising slack in resource utilization; inflation was forecast to remain low in 2010 and 2011. Participants generally judged that the degree of uncertainty surrounding the outlook for both economic activity and inflation was greater than historical norms. Most participants viewed the risks to growth as skewed to the downside, and nearly all saw the risks to the inflation outlook as either balanced or tilted to the downside. Participants also reported their assessments of the rates to which macroeconomic variables would be expected to converge over the longer run under appropriate monetary policy and in the absence of further shocks to the economy. The central tendencies of these longer-run projections were 2.5 percent to 2.7 percent for real GDP growth, 4.8 percent to 5.0 percent for the unemployment rate, and 1.7 percent to 2.0 percent for the inflation rate.

Footnotes

1. A list of abbreviations is available at the end of this report.  Return to text