PRINTMarket Update -- Economic Comment
February 27, 2008
Ben Bernanke endured two days of legislative grilling on Capitol Hill this week. He did a good job answering the legislators' questions, but one important question remained unanswered – is monetary policy working? In January, the Fed slashed the federal funds rate by a hefty 125 basis points. The plan was to offset the effects of tighter credit conditions and cushion the economic downturn.
At first, it appeared as though the Fed's action was successful. Borrowing rates declined sharply in January, and the tone in the financial markets was notably less gloomy. Indeed, there was a surge in mortgage refinancing in January. Improvement did not last, however. Long-term borrowing rates have increased markedly from their January lows and financial credit conditions are as tight as they were prior to this latest round of Fed easing. While it does not appear as though the Fed succeeded in stimulating the economy with their January easing, their actions did help settle the money markets, and U.S. LIBOR rates have fallen by more than 200 basis points since December to near 3%. This is a significant reprieve for homeowners with variable rate mortgages. Thus, while the Fed's action has not turned the economy around, it has helped mitigate the downturn.
Does the Fed need to do more?
We think the Fed needs to do a lot more, and we expect the funds rate will be ultimately lowered to 1.75% this year from its current level of 3%. Even then, we do not expect the economy to return to a moderate growth pace until the banking system and the credit markets start functioning more normally again. In order for that to happen, market participants need more clarity about the likely performance of the collateral backing bonds, and they need to have increased confidence about the level of counterparty risk embedded in over-the-counter transactions. If this can be accomplished, investors might return to buy mode, and commercial banks and broker-dealers will be able to free up or raise capital. If so, key market players can go back to committing capital to the fixed income markets. This grease, in turn, will hopefully get the wheels on the bus turning again.
There are a number of events that could help unfreeze the credit markets. Included in this list: a recapitalization of the big monoline insurers that allows them to keep their AAA ratings; a stabilization of the housing market that makes the bottom in house prices visible; increased confidence that commercial construction is not about to follow residential construction into the bath; and conviction that the likely deterioration in consumer credit will not completely erode the value of consumer-linked bonds.
We believe the economy is in a recession, and this will lead to further deterioration in the collateral that backs structured-credit bonds. At this point, however, the prices of many asset-backed bonds already reflect recession-like conditions. This suggests that we are approaching an inflection point, but with bank and broker-dealer balance sheets highly constrained, the wheels are just not turning. Until this happens, credit markets will not function normally. And, until the credit markets start to function more normally again, monetary policy will be less forceful. This is why we believe the Fed will need to remain aggressive in their easing actions and eventually lower the funds rate another 125 basis points. With anything less, the Fed risks exacerbating the situation.
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