2008 Annual Report

THE ECONOMY AND MONETARY POLICY*

As 2009 began, the U.S. economy was in the midst of a serious recession. Real gross domestic product (GDP) fell sharply late in 2008 and apparently again in early 2009. These declines occurred despite aggressive moves by the Federal Reserve that lowered the federal funds rate to near zero and approximately tripled the size of its balance sheet. Since the beginning of the recession, 4.3 million jobs have been lost, with the unemployment rate reaching 8.1% in February 2009.

chart depicting 2008 economic growth Weak labor markets and the early-year increases in energy prices held back growth in real incomes in 2008. This, along with strains in financial markets and substantial declines in household wealth, led to a large drop in consumer spending over the second half of the year. Residential investment continued to deteriorate throughout 2008, with construction, new home sales and home prices all declining further. Business spending also contracted sharply in the second half of 2008, and weakening foreign activity and the higher U.S. dollar reduced the strong contribution to growth from net exports that had occurred in the first half of the year.

chart depicting 2008 inflation levels Measures of consumer price inflation decreased in 2008 from the prior year. Inflationary pressures eased substantially over the course of the year, reflecting falling prices for energy and other commodities later in the year, declining import prices, and increases in resource slack due to diminished economic activity.

Responding to the Credit Crisis

In 2008, the tightening of credit conditions began to weigh on economic activity. Problems with several major financial institutions intensified market participants' concerns about potential losses on a range of assets as well as the ability of counterparties to meet contractual obligations. This further increased risk aversion and sparked a "flight to quality" toward traditionally safe assets such as U.S. Treasuries. Toward the end of 2008, a further pullback in risk-taking occurred, spurred by further disruptions in short-term funding markets as well as a more pessimistic outlook for the economy. This led to even lower equity prices, higher risk spreads, and tighter credit markets, all of which fed back into further declines in real and financial activity.

In response to these extraordinary events, the Fed made large adjustments to its traditional monetary policy instrument — the federal funds rate. At the Federal Open Market Committee (FOMC) meeting in December 2008, the federal funds rate was essentially cut to zero — 300 basis points lower than where it was at the start of the year. Although the corresponding injections of liquidity helped credit conditions, it became clear that further extensions of central bank liquidity would be necessary to facilitate market functioning. These included increasing the maturity of discount window loans from overnight to 90 days and the expansion of the Term Auction Facility (TAF) to provide loans through auctions in order to overcome stigma associated with discount window borrowing.

chart depicting Federal Funds Rate target from 2005 through 2008 Furthermore, the sudden demise of several non-depository institutions led to the creation of a number of new lending facilities under emergency powers granted by the Federal Reserve Act. These measures were first aimed at broker-dealers, who have a large-scale presence in short-term funding markets. Subsequently, lending facilities were introduced to help work through disruptions in the money market mutual fund and commercial paper markets. The Fed also began to purchase debt and mortgage-backed securities issued by government-sponsored enterprises (GSEs) to support the flow of credit in mortgage markets.

Moving Forward

The Fed has not been alone in dealing with this crisis, as both the FDIC and the U.S. Treasury have taken numerous actions aimed at addressing difficulties in financial markets. These actions, along with market forces, will help move the U.S. economy back toward financial stability. Still, it could take some time before financial markets function in a manner that noticeably facilitates economic activity. Consequently, real GDP is likely to decline in the first half of 2009, before stabilizing later in the year, with important support coming from monetary and fiscal policy. However, the unemployment rate is likely to rise into 2010 as it could take some time for the rebound in activity to be strong enough to close resource gaps.

Although futures markets expect some rise in the prices for energy and other commodities, resource slack should result in another reduction in inflation in 2009 and a further edging down in 2010. Over the longer run, overall inflation is expected to average somewhere in the range of 2%, which is a rate consistent with price stability. However, there is notable risk that inflation will run a good deal below this range in the medium term.

chart depicting the Federal Reserve's assets in 2008 In the coming year, several new policy tools will be employed, including the Term Asset-Backed Security Loans Facility (TALF), a joint program with the Treasury. The first TALF lending is aimed at reducing funding pressures in the student, consumer, and small business asset-backed securities (ABS) markets. Subsequent extensions are likely to address pressures in other ABS markets such as commercial mortgage-backed securities. The Fed has also begun buying longer-term Treasury securities to reduce borrowing costs for a range of longer-term instruments and expanded its purchases of GSE securities. However, as economic activity recovers and financial conditions normalize, the use of such tools will have to be scaled back, the size of our balance sheet will have to be reduced, and the FOMC will return to its traditional focus on the federal funds rate.

Source for all charts: Haver Analytics
*This essay reflects information available as of March 27, 2009.