Part 3: Monetary Policy in 2007 and Early 2008

After easing the stance of monetary policy 100 basis points over the second half of 2007, the Federal Open Market Committee (FOMC) lowered the target federal funds rate 225 basis points further in the first half of 2008.¹¹ The Federal Reserve also took a number of additional actions to increase liquidity and to improve the functioning of financial markets.

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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. 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, core inflation had edged up in recent months, and considerable uncertainty surrounded the inflation outlook. On balance, 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. Strains in some financial markets had intensified, and incoming evidence had reinforced the view that the outlook for economic activity was weak. Participants observed that investors apparently were becoming increasingly concerned about the economic outlook and downside risks to activity and that these developments could lead to an excessive pullback in credit availability. In light of these developments, all 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 judged that appreciable downside risks to growth remained. Although inflation was expected to edge lower over the course of 2008, participants underscored their view 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 a continued tightening of financial conditions. With the contraction in the housing sector intensifying and a range of financial markets remaining under pressure, economic growth was expected to stay soft in the first half of 2008 before picking up strength in the second half. However, the ongoing weaknesses 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, the potential for adverse feedback between the financial markets and the economy was a significant risk. 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 this 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.

In a conference call on March 10, the Committee reviewed financial market developments and considered proposals aimed at supporting the liquidity and orderly functioning of those markets. In light of the sharp deterioration of some key money and credit markets, the Committee approved the establishment of the Term Securities Lending Facility, under which primary dealers would be able to borrow Treasury securities from the System Open Market Account for a term of approximately one month against any collateral eligible for open market operations and the highest-quality private residential mortgage-backed securities (MBS).¹² The new facility was designed to alleviate pressures in the financing markets for securities. In addition, the Committee agreed to expand the existing reciprocal currency agreements with the European Central Bank and the Swiss National Bank to $30 billion and $6 billion, respectively, and to extend the terms of these agreements through September 2008. Over the next few days, financial market strains intensified further. On March 16, the Federal Reserve announced emergency measures to bolster liquidity and promote orderly functioning in financial markets, including the approval of the financing arrangement associated with the acquisition of The Bear Stearns Companies, Inc., by JPMorgan Chase & Co. and the establishment of the Primary Dealer Credit Facility to improve the ability of primary dealers to provide financing to participants in securitization markets. In addition, the primary credit rate was lowered 25 basis points, and the maximum term of primary credit loans was extended to 90 days.

When the Committee met on March 18, financial markets continued to be under great stress, particularly the markets for short-term collateralized and uncollateralized funding. Spreads on interbank loans and lower-rated commercial paper had widened over the intermeeting period, and obtaining credit through repurchase agreements backed by agency and private-label MBS had become more difficult amid reports of increased margin, or "haircuts," being required by lenders. Yields on Treasury bills and repurchase agreements backed by Treasury securities had plummeted, reflecting investors' heightened demand for the safest assets.

Participants at the March 18 FOMC meeting noted that prospects for both economic activity and near-term inflation had deteriorated since January, and many thought that some contraction in economic activity in the first half of 2008 was likely. Although the economy was expected to recover in the second half and to grow further in 2009, considerable uncertainty surrounded this forecast. Some participants expressed concern that falling house prices and financial market stress might lead to a more severe and protracted downturn than anticipated. Recent readings on inflation had been elevated, and some indicators of inflation expectations had risen. However, a flattening-out of prices for oil and other commodities--as implied by futures prices--and the projected easing of pressures on resources were expected to contribute to some moderation in inflation. All in all, most members judged that a 75 basis point reduction in the target federal funds rate, to 2-1/4 percent, was appropriate to address the combination of risks of slowing economic growth, inflationary pressures, and financial market disruptions. In its statement, the Committee highlighted the further weakening in the outlook for economic activity, but it also emphasized the importance of monitoring inflation developments carefully.

The data reviewed at the meeting on April 29 and 30 indicated that economic growth had been weak in the first three months of 2008 and that core consumer price inflation had slowed, but that overall inflation had remained elevated. FOMC participants indicated that these developments had been broadly consistent with their expectations. Conditions across a number of financial markets were judged to have improved since the March meeting, but financial markets remained under considerable stress. Although the likelihood that economic activity would be severely disrupted by a sharp deterioration in financial markets had apparently receded, most participants thought that the risks to economic growth were still skewed to the downside. All participants expressed concern about upside risks to inflation posed by rising commodity prices and the depreciation of the dollar, but some participants noted that the downside risks to economic activity also implied that there were downside risks to price pressures as well. Participants expressed significant uncertainty concerning the appropriate stance of monetary policy in these circumstances. Some participants noted that the level of the federal funds target, especially when compared with the current rate of inflation, was relatively low by historical standards. Others noted that financial market strains and elevated risk spreads had offset much of the effects of policy easing on the cost of credit to borrowers. On balance, most members agreed that the target for the federal funds rate should be lowered 25 basis points, to 2 percent. The Committee expected that the policy easing would help to foster moderate growth over time without impeding a moderation in inflation. The Committee agreed that, in light of the substantial policy easing to date and the ongoing measures to foster financial market liquidity, the risks to growth were now more closely balanced by the risks to inflation.

In view of persisting strains in funding markets, the FOMC also approved proposals to expand the liquidity arrangements that had been put in place in previous months. The reciprocal currency agreements with the European Central Bank and Swiss National Bank were increased to $50 billion and $12 billion, respectively, and both were extended through January 2009. The collateral accepted by the Term Securities Lending Facility was expanded to include all AAA-rated asset-backed securities. In addition, Chairman Bernanke announced his intention to expand the Term Auction Facility to $150 billion under authority previously delegated by the Board of Governors.

At the time of the meeting held June 24 and 25, the available indicators suggested that economic activity in the first half of the year had not been as weak as had been expected in April. Nevertheless, several factors were viewed as likely to restrain activity in the near term, including the contraction in the housing sector, sharply higher energy prices, and continued tight credit conditions. Although financial market conditions generally appeared to have improved modestly since the April meeting, participants noted that the potential for adverse financial market developments still posed significant downside risks to economic activity. The further large increase in energy prices also prompted an upward revision of projections for overall inflation in the second half of 2008. Most participants expected that a leveling-out of energy prices and continued slack in resource utilization would lead inflation to moderate in 2009 and 2010, but the persistent tendency in recent years for commodity prices to exceed the trajectory implied by futures market prices engendered considerable uncertainty around the projected moderation of inflation. Members generally agreed that the downside risks to growth had eased somewhat since the previous FOMC meeting while the upside risks to inflation had intensified. Against this backdrop, most members judged that maintaining the current stance of policy at this meeting represented an appropriate balancing of the risks to the economic outlook. Nonetheless, policymakers recognized that circumstances could change quickly and noted that they might need to respond promptly to incoming information about the evolution of risks.

Footnotes

11. Members of the FOMC in 2008 consist of members of the Board of Governors of the Federal Reserve System plus the presidents of the Federal Reserve Banks of Cleveland, Dallas, Minneapolis, New York, and Philadelphia. Participants at FOMC meetings consist of members of the Board of Governors and all Reserve Bank presidents.  Return to text

12. By notation vote completed on March 20, AAA-rated commercial MBS were added to the list of acceptable collateral.  Return to text