Part 3: Monetary Policy in 2007 and Early 2008

Throughout the first half of 2007, the available information pointed to a generally favorable economic outlook despite the ongoing correction in the housing market. Indicators of consumer and business spending were somewhat uneven, but their generally positive trajectories suggested that the housing market developments were, as yet, having little effect on the broader economy. Net exports, spurred in part by a falling dollar, were providing support to economic growth. Outside of the subprime mortgage sector, financial conditions in general were fairly accommodative. The Federal Open Market Committee expected core inflation to moderate from the somewhat elevated level that had prevailed at the start of the year, but high resource utilization had the potential to sustain upward pressure on inflation. As a result, during the first half of the year, the Committee consistently noted in its statement that its predominant policy concern was that inflation would fail to moderate as expected. However, in part owing to indications of increasing weakness in the housing sector, the Committee emphasized in the statements issued at the conclusion of its March, May, and June meetings that its future policy actions would depend on the evolution of the outlook for both inflation and economic growth.

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When the Committee met on August 7, financial markets had been unusually volatile for a few weeks, and credit conditions had become somewhat tighter for some households and businesses. Participants in FOMC meetings (Board members and Reserve Bank presidents) noted that adjustments in the housing sector had the potential to prove deeper and more prolonged than had seemed likely earlier in the year, and a further underperformance in the housing area represented a significant downside risk to the economic outlook. Nonetheless, incoming data indicated that economic growth had strengthened in the second quarter, as a quicker pace of business spending offset a slowdown in consumer outlays. Participants believed that the economy remained likely to expand at a moderate pace in coming quarters, supported in part by continued growth in business investment and a robust global economy. Although core inflation had moved lower since the start of the year, participants were still concerned about several factors--including a continued high level of resource utilization--that could augment inflation pressures. They believed that a sustained moderation in those pressures had yet to be convincingly demonstrated. As a result, the FOMC decided to leave the target for the federal funds rate unchanged at 5-1/4 percent and, despite somewhat greater downside risks to growth, reiterated that the predominant policy concern remained the risk that inflation would fail to moderate as expected.

In the days following the August 7 FOMC meeting, financial conditions deteriorated rapidly as market participants became concerned about counterparty credit risk and their access to liquidity. After an FOMC conference call on August 10 to review worsening strains in money and credit markets, the Committee issued a statement indicating that the Federal Reserve would provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the FOMC's target rate of 5-1/4 percent. As conditions deteriorated further, the Committee met again on August 16 by conference call to discuss the potential usefulness of various policy responses. The following day, the Federal Reserve announced changes in discount window policies to facilitate the orderly functioning of short-term credit markets. Furthermore, the FOMC released a statement indicating that the downside risks to growth had increased appreciably and that the Committee was prepared to act as needed to mitigate adverse effects on the economy. (The box entitled "The Federal Reserve's Responses to Financial Strains" provides additional detail on the outcomes of these conference calls and other measures taken by the Federal Reserve to facilitate the orderly functioning of financial markets over the second half of the year, including coordinated actions with other central banks.)

At the time of the September FOMC meeting, financial markets remained volatile. Liquidity in short-term funding markets was significantly impaired amid heightened investor unease about exposures to subprime mortgages and to structured credit products more broadly. Credit generally remained available for most businesses and households, but the Committee noted that the tighter credit conditions for other borrowers had the potential to restrain economic growth. Incoming economic data were mixed: Consumer spending appeared to have strengthened from its subdued second-quarter pace, but a further intensification of the housing contraction and slowing employment growth suggested a weaker economic outlook. Participants noted that incoming data on core inflation continued to be favorable and that the downwardly revised economic outlook implied some lessening of pressures on resources, but they remained concerned about possible upside risks to inflation. To forestall some of the adverse macroeconomic effects that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time, the FOMC lowered the target for the federal funds rate 50 basis points, to 4-3/4 percent. The Committee also noted that recent developments had increased the uncertainty surrounding the economic outlook and stated that it would act as needed to foster price stability and sustainable economic growth.

At the time of the October FOMC meeting, the data indicated that economic growth had been solid in the third quarter. A pickup in consumer spending and continued expansion of business investment suggested that spillovers from the turmoil in the housing and financial markets had been limited to that point. Although strains in financial markets had eased somewhat on balance, tighter credit conditions were thought likely to slow the pace of economic expansion over coming quarters. Furthermore, the downturn in residential construction had deepened, and available indicators pointed to a further slowing in housing activity in the near term. FOMC meeting participants noted that readings on core inflation had improved somewhat over the year and anticipated that some of the moderation likely would be sustained. Nonetheless, participants expressed concern about the upside risks to the outlook for inflation, stemming in part from the effects of recent increases in commodity prices and the significant decline in the foreign exchange value of the dollar. Against that backdrop, the Committee decided to lower the target for the federal funds rate 25 basis points, to 4-1/2 percent, and judged that the upside risks to inflation roughly balanced the downside risks to growth.

Also at the October meeting, the Committee continued its discussions regarding communication with the public. Participants reached a consensus on increasing the frequency and expanding the content of their periodic economic projections. Under the new procedure, which was announced on November 14, the FOMC compiles and releases the projections made by the Federal Reserve Governors and Reserve Bank presidents four times each year, at approximately quarterly intervals, rather than twice each year, as had been the practice since 1979. In addition, the projection horizon has been extended from two years to three years. FOMC meeting participants provide projections for the increase in the price index for total personal consumption expenditures (PCE) as well as projections for real GDP growth, the unemployment rate, and core PCE price inflation. Summaries of the projections and an accompanying narrative are published along with the minutes of the FOMC meeting at which they were discussed. Beginning with the present report, the projections made in January are included in the February Monetary Policy Report to the Congress, and the projections made in June are included in the July report.

In a conference call on December 6, Board members and Reserve Bank presidents reviewed conditions in domestic and foreign financial markets and discussed two proposals aimed at improving market functioning. The first proposal was for the establishment of a temporary Term Auction Facility (TAF), which would provide term funding through an auction mechanism to eligible depository institutions against a broader range of collateral than that used for open market operations. The second proposal was to set up a foreign exchange swap arrangement with the European Central Bank to address elevated pressures in short-term dollar funding markets. At the conclusion of the discussion, the Committee voted to direct the Federal Reserve Bank of New York to establish and maintain a reciprocal currency (swap) arrangement for the System Open Market Account with the European Central Bank.¹³ The Board of Governors approved the TAF via notation vote on December 10.

At the Committee's meeting on December 11, participants noted that incoming information suggested economic activity had decelerated significantly in the fourth quarter. The housing contraction had steepened further, and participants agreed that the sector was weaker than had been expected at the time of the Committee's previous meeting. Moreover, spillovers from housing to other parts of the economy had begun to emerge: Consumption spending appeared to be softening more than had been anticipated, and employment gains appeared to be slowing. Participants noted that evidence of further deterioration in the credit quality of mortgages and other loans to households appeared to be spurring lenders to further tighten the terms on new extensions of credit for a widening range of credit products. Financial market conditions had worsened significantly. The financial strains were exacerbated by concerns related to year-end pressures in short-term funding markets, and similar stresses were evident in the financial markets of major foreign economies. Although a surge in energy prices pushed up headline consumer price inflation during September and October, Committee members agreed that the inflation situation had changed little from the time of the previous meeting. In these circumstances, the FOMC lowered the target for the federal funds rate a further 25 basis points, to 4-1/4 percent, and, given the heightened uncertainty, the Committee decided to refrain from providing an explicit assessment of the balance of risks. The Committee also indicated that it would continue to assess the effects of financial and other developments on economic prospects and act as needed to foster price stability and sustainable economic growth. In addition to that policy move, the Federal Reserve and several other central banks announced on December 12 the measures they were taking to address elevated pressures in short-term funding markets. The Federal Reserve announced the creation of the TAF and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank.

In a conference call on January 9, the Committee reviewed recent economic data and financial market developments. The information, which included weaker-than-expected data on home sales and employment for December, as well as a sharp decline in equity prices since the beginning of the year, suggested that the downside risks to growth had increased significantly since the time of the December FOMC meeting. Moreover, participants cited concerns that the slowing of economic growth could lead to a further tightening of financial conditions, which in turn could reinforce the economic slowdown. However, participants noted that core inflation had edged up in recent months and believed that considerable uncertainty surrounded the inflation outlook. Participants were generally of the view that substantial additional policy easing might well be necessary to support economic activity and reduce the downside risks to growth, and they discussed the possible timing of such actions.

On January 21, the Committee held another conference call. Participants in the call noted that strains in some financial markets had intensified and that incoming evidence had reinforced their view that the outlook for economic activity was weak. Participants observed that investors apparently were becoming increasingly concerned about the economic outlook and that these developments could lead to an excessive pullback in credit availability. Against that background, members judged that a substantial easing in policy was appropriate to foster moderate economic growth and reduce the downside risks to economic activity. The Committee decided to lower the target for the federal funds rate 75 basis points, to 3-1/2 percent, and stated that appreciable downside risks to growth remained. Although inflation was expected to edge lower over the course of 2008, participants underscored that this assessment was conditioned upon inflation expectations remaining well anchored and stressed that the inflation situation should continue to be monitored carefully.

The data reviewed at the regularly scheduled FOMC meeting on January 29 and 30 confirmed a sharp deceleration in economic growth during the fourth quarter of 2007 and continued tightening of financial conditions. With the contraction in the housing sector intensifying and a range of financial markets remaining under pressure, participants generally expected economic growth to remain weak in the first half of 2008 before picking up strength in the second half. However, the continuing weakness in home sales and house prices, as well as the tightening of credit conditions for households and businesses, were seen as posing downside risks to the near-term outlook for economic growth. Moreover, many participants cited risks regarding the potential for adverse feedback between the financial markets and the economy. Participants expressed some concern about the disappointing inflation data received over the latter part of 2007. Although many expected that a leveling out of prices for energy and other commodities, such as that embedded in futures markets, and a period of below-trend growth would contribute to some moderation in inflation pressures over time, the Committee believed that it remained necessary to monitor inflation developments carefully. Against that backdrop, the FOMC decided to lower the target for the federal funds rate 50 basis points, to 3 percent. The Committee believed that the policy action, combined with those taken earlier, would help promote moderate growth over time and mitigate the risks to economic activity. However, members judged that downside risks to growth remained.

Footnotes

13. A swap arrangement with the Swiss National Bank was approved by the Committee on December 11. Return to text