FOMC March Meeting: Buy Treasuries, More Agency MBS

Economy Off-Target - Provide More Liquidity!

The Federal Open Market Committee (FOMC) left little doubt that they will continue to "support the functioning of financial markets and stimulate the economy." Effectively the FOMC will do this through 1) maintaining a 0 to ¼ percent target range for the federal funds rate, 2) increasing the size of the Federal Reserve’s balance sheet by buying more agency mortgage-backed securities, 3) purchasing up to $300 billion of Treasuries over the next six months and 4) launching the Term Asset-Backed Securities Loan Facility. Today’s Fed action is definitely a plus; however a long period of easy monetary policy may generate problems down the road.

Growth: "Economy Continues to Contract"

"Near-term economic outlook is weak." The FOMC writes that "job losses, declining equity and housing wealth and tight credit conditions have weighed on consumer sentiment and spending." Our outlook is for further declines in industrial production, housing and employment for the second quarter. In addition, we expect consumer spending to be flat. The domestic private economy remains in recession as weak growth in real disposable income for consumers and lower profits for non-financial companies dictate a lack of spending power for consumer and investment goods. The deterioration in labor market conditions (Figure 1) continues along with declines in consumer spending and business investment.

Looking ahead, the FOMC expects its policy actions "will contribute to a gradual resumption of sustainable economic growth." Our expectation is that we will see positive economic growth by the fourth quarter although we also anticipate continued job losses, sub-par personal income growth and declining corporate profits at least through the third quarter.

Figure 1

Inflation: "Remains Subdued"

The FOMC cited that they see "some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term." This repeats the January statement. Such a comment supports the FOMC’s suggestion that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time." There certainly is no incentive from the inflation data for the Fed to alter its ultra-easy policy.

Credit Markets: Full Speed Ahead with Liquidity

The TED spread, an indicator of stress in money markets, which had widened to over 400 basis points, now suggests significant liquidity at the short-end of yield curve (Figure 2). At the long-end of the yield curve, credit markets were constrained by the process of seeking a new risk/reward balance. The FOMC’s actions on agencies and Treasuries are aimed at addressing these longer-maturity/lower credit issues.

Figure 2

For Decision-Makers: Happy Days in Short-Run - Problems Longer-Term

In response to all this liquidity, the outlook for the economy and credit markets will certainly improve. Longer-term there remains the concern about too much liquidity and the monetization of Treasury debt. The rapid expansion of the balance sheet and negative real interest rates at the short end have raised fears that inflation will rise and that sub-three percent ten-year Treasury yields provide no inflation protection. As a result, we expect that ten year Treasury rates will drift upward over the rest of this year.

In the short run, Fed easing is a plus. Over the longer run, however, a long period of easy monetary policy may generate more problems down the road with a combination of higher inflation premiums and a weaker dollar to boot. Higher long-term rates are the likely outcome.

For the FOMC, the two objectives of financial stability and economic recovery remain the intermediate-term policy targets. Yet, both targets are a distance away from being reached. The longer-term goal is, of course, price stability with sustainable real economic growth. But the significant expansion of the Fed’s balance sheet in an environment of large federal budget deficits suggests a rising risk profile of an ugly bond market in the future.

Wachovia Corporation
http://www.wachovia.com

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