FOMC December Meeting: To Boldly Go...

Where No FOMC Has Gone Before

Today the Federal Open Market Committee (FOMC) took two bold steps forward in the conduct of policy. First the Fed moved to a range for the Fed funds target range. This effectively recognizes the Fed's difficulty in controlling any precise funds rate at this low target and under current circumstances. Second, the Fed will "employ all available tools to promote the resumption of sustainable growth and to preserve price stability." Effectively, the Fed is committing to a continued expansion of its balance sheet to support financial markets and the U.S. economy. The Fed lowered its target for the federal funds rate by at least 75 basis points to a range of zero to 25 basis points, the lowest rate in more than fifty years. Monetary policy continues to adjust to an environment of economic recession, lower inflation expectations and the imbalance of asset valuations.

"Please, Spock, do me a favor...and don't say it's fascinating"

Unfortunately, the domestic private economy remains in recession as weak growth in real disposable income for consumers and lowered profits for non-financial companies dictate a lack of spending power for consumer and investment goods. The Fed highlighted deterioration in labor market conditions (Figure 1) along with declines in consumer spending and business investment. The recent dip in gas prices and the broader consumer price index supported the case for the FOMC to cite expectations for inflation to moderate further (Figure 2).

Figure 1

Figure 2

"It has always been easier to destroy than create" -Spock

Over the last year we have witnessed the destruction of credit markets and now we face the difficult task of increasing trust and liquidity in the marketplace. In its statement, the Federal Open Market Committee suggested that recent policy actions should help over time to improve credit conditions. Financial markets have evidenced some very modest improvement in credit spreads, but the search for that new equilibrium between risk and reward remains in progress. For example, both the price and the availability of credit to the high grade and high yield bond markets have assumed a very different tone from earlier in this decade. Meanwhile, the TED spread widened to over 400 basis points and has now retreated below 300 basis points (Figure 3). Commercial paper issuance has increased especially for commercial paper maturities over 81 days. The market and the economy remain constrained by the paradox of lemons—make more lemonade. This process will take time and supports continued Fed easing at the short end of the curve and credit aversion in the private market.

Figure 3

The FOMC emphasized that the "policy going forward will be to support the functioning of financial markets..." The Fed will purchase agency debt and mortgage-backed securities as well as "evaluating the potential benefits of purchasing longer-term Treasury securities." This is effectively an attempt to bring down mortgage rates directly, as well as influence long Treasury rates.

"Scotty, We Need More Power" Captain Kirk

In response to the weakness in the economy and credit issues, the Fed has lowered the real fed funds rate to levels below that of the entire post 1992 period (Figure 4). However, there is a legacy of criticism of the 2002-2004 period of easy monetary policy that such policy led to a boom in credit-financed consumer spending that has generated the problems we have today. The Fed has been very cautious in supplying liquidity to the marketplace to avoid repeating the sustained period of a low nominal funds rate experience. In contrast, today's statement makes it clear the Fed will supply whatever power is necessary to rev-up the economic engine.

Figure 4

In the short run, slow growth and credit issues will offset Fed easing and the recovery in the economy will be slow in coming. There simply is no easy out for the financial markets, the economy or policy makers. We may in fact witness a long period of easy monetary policy that may generate more problems down the road and yet provide little quick relief for the economy. The great American financial work-out continues.

"Live Long and Prosper"

Wachovia Corporation
http://www.wachovia.com

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