Fed lowers funds and discount rates by 25 basis points, but tempers its concern about future growth

April 30, 2008

The Federal Reserve cut the Fed funds by 25 basis points today to 2.00% with the discount rate cut a similar amount to 2.25%. The cut was a reflection of indications that "economic activity remains weak" highlighting softening labour markets. As well, the central bank mentioned that "Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters."

Tempering even more aggressive actions were ongoing concern about inflation and indications that inflation expectations have been on the rise in recent months. While the central bank expressed confidence that the expected slowing in growth and a leveling-out in commodity prices will result inflation moderating in subsequent quarters, it indicated inflation developments would continue to be moderated closely.

As to what the statement implied going forward, there was no explicit statement about the central bank moving onto the sidelines. However the text implied a less pressing need to ease further. For example, the Fed dropped the sentence "that downside risks to growth remain" that was contained in the March 18 FOMC statement. As well, economic activity in the March had been characterized as "weakening further'" as opposed to the comment today that it "remains weak." Similarly, credit conditions had previously been characterized as "tightening further" are more simply referred to now as "tight." The statement reiterated the point that the FOMC would continue to monitor the incoming data and act "as needed" though this also implied less urgency compared to the comment in March to respond "in a timely manner as needed." Today's statement also makes mention of "the substantial easing of monetary policy to date."

Eight of the ten Committee members voted in favour of the 25-basis point reduction in Fed funds with the two dissenters, Fisher and Plosser" favouring no change in the Fed funds rate. These two individuals had also dissented from the 75-basis point cut in March favouring less aggressive action.        

Highlights from the Fed's Beige Book

April 16, 2008

 

The Beige Book report, compiled in preparation for the April 29-30 FOMC meeting, emphasized a broadening the economic weakness across most Fed districts. The report also made a number of references to rising input costs faced by firms, although these were seemingly not getting passed along as "most districts reported little change in retail prices."

The report indicated that the housing market remained sluggish throughout the country. In fact, the most upbeat comment that could be offered was that there had been no "quickening in the pace of deterioration." That said, it was reported that there had been some stabilization, albeit at very low levels, in residential mortgage lending by banks. The report indicated that commercial real estate markets were generally steady or softening in most areas.

With respect to consumer spending, once again there were indications of broad-based weakening with softening occurring "across most of the country." Indications of rising weakness in household spending contributed to widespread slowing in bank lending to consumers. The report also indicated that credit quality was reported to have deteriorated since the last Beige Book in March.
The report did flag some bright spots in the economy with tourism being characterized as robust. This strength likely reflected the earlier depreciation of the U.S. dollar. Similarly, the reports from the agricultural sector were generally upbeat reflecting "improved growing conditions and favorable pricing." Rising prices were also helping to support the energy sector. Manufacturing activity was varied overall though strong demand was reported for aerospace, aircraft, defense goods, steel and food products.

As to labour market developments, it was reported that "employment levels appeared to be little changed, on balance, from recent months." This characterization, although not particularly robust, seemed less dire than expected in the face of payroll employment declining during the first three months of 2008.

The discussion on inflation was dominated by reports of higher prices for various inputs costs. Manufacturers were reported to be planning on trying to pass on these increases. However, at the retail level, the report indicated that prices were generally little changed with, in fact, two districts reporting some moderation in consumer prices.

Indications of the broadening of economic weakness reinforce the impression that more interest cuts by the Fed are in the offing. The absence of upward inflation price pressure at the retail level suggests no obstacle on this front, although the reports of upward input cost pressures will keep the Fed wary about easing too aggressively. Our forecast assumes that Fed funds will be lowered a further 75 basis points by mid-2008, with 50 basis points coming at the end of this month and the final cut emerging from the June 24-25 FOMC meeting.

 

Minutes of March 18 FOMC meeting

April 8, 2008
 
The March 18 FOMC meeting concluded with the Fed opting to cut Fed funds by 75 basis points though with two dissenting votes, by Plosser and Fisher, both of whom preferred to see a more modest cut. The minutes of the meeting released this afternoon make clear that the central bank felt that they were confronting two divergent trends between growth and inflation. "FOMC participants noted that prospects for both economic activity and near-term inflation had deteriorated in view of increasingly fragile financial markets and tighter credit conditions, rising prices for oil and other commodities, and the deepening contraction in the housing sector." However, concern about the near-term growth prospects seemingly dominated with the Fed opting to undertake another relatively aggressive reduction in interest rates.

The greater weakening in growth was attributed to "slower growth in consumer spending and softening in the labor market." Also contributing to the greater weakness were indications "that financial markets remained under considerable stress, and that the tightening of credit conditions and the deepening of the housing market contraction were likely to weigh on economic growth over the next few quarters." The minutes also revealed that the Fed staff had substantially revised down its outlook for growth and was now allowing for a contraction in GDP over the first half of this year.

 

Beyond this, a slow rise over the second half was projected helped along by the recently passed fiscal stimulus package. However, the downside risks to this outlook were relatively dire with some members indicating "that a prolonged and severe economic downturn could not be ruled out given the further restriction of credit availability and ongoing weakness in the housing market."

With respect to inflation, a majority of members seemed to be of the view that the weaker growth and an expected leveling out of energy and commodity prices should act to moderate overall inflation in coming quarters. However, it was also acknowledged that recent upward inflation pressures were playing out currently despite indications of a weakening in economic activity. Thus it was agreed that the Fed statement following the FOMC meeting and rate cut should acknowledge recent indications of rising price pressure though reiterate the view that the weakening in economic activity would prevent this trend from continuing.

The minutes put considerable emphasis on the various measures the Fed had undertaken, beyond cutting interest rates, to increase liquidity in the system. This largely entailed both accepting as collateral various assets whose market had seen markedly diminished trading and offering this option to an increasingly larger group of market participants. The FOMC members wanted the statement to acknowledge these actions and the expectation that they would prove to be successful in promoting moderate growth over time.

 

In summary, the minutes emphasized a deterioration in both the near-term growth outlook and recent inflation performance. However, a more dire and pressing case was made in terms of the weakening growth outlook. This was emphasized both by the acknowledgement that the Fed staff was now assuming declining growth sometime over the first half of this year and that some members saw the risk of a prolonged and severe economic downturn. The greater emphasis of these risks to growth over a deterioration in the inflation outlook not only warranted the aggressive 75-basis point cut coming out of the March 18 FOMC meeting but also made clear that further rate reduction are likely. Our expectation is that Fed funds will be lowered by a further 75 basis points by mid-year sending Fed funds to a near-term low of 1.50%.