The Fed: Measuring the Aftershocks

By BW staff

The Federal Reserve's Mar. 18 announcement that it would it would boost the size of its balance sheet by purchasing up to $300 billion of longer-term Treasury securities and up to an additional $750 billion of agency mortgage-backed securities was greeted with initial jubilation in the markets, with both stocks and Treasuries rallying. But investors began to have some second thoughts about the plan on Mar. 19, including its potential to stoke inflation in the longer term, and the stock and bond markets finished lower.

If that weren't enough, the Fed followed up the bold money pumping plan by kicking off the Term Asset-Backed Securities Lending Facility (TALF) on Mar. 19. This program has spurred optimism that it will revitalize consumer and business lending.

What did Wall Street economists have to say about the continuing reverberations of the Fed's actions, the launch of TALF, and other topics on Mar. 19? Here's a sampling, as compiled by BusinessWeek staff:

Andrew Tilton, Goldman Sachs

The Fed offered a kitchen sink of "unconventional easing" measures [on Mar. 18], including commitments to purchase up to $1.15 trillion of Treasury and agency securities. We view this as a positive step toward easing financial conditions and supporting the eventual stabilization and recovery of the economy. Last week, we estimated that it would "cost" the Fed $1 trillion to $1.6 trillion of balance-sheet expansion to generate an unconventional easing in financial conditions equivalent to a 100 [basis point] cut in the funds rate…. [T]he Fed is also trying to increase the flow of lending directly, via the Term Asset-Backed Securities Lending Facility (TALF) program. Officials are so optimistic about this approach that they have hinted via media reports at a second major expansion of the concept before the first subscription period has even been completed.

If all of the incremental issuance translated into new lending, and new lending translated one-for-one into domestically manufactured vehicle sales, this would boost GDP by roughly 0.5% at a balance-sheet cost of less than $100 billion. This implies the TALF approach could be an order of magnitude more efficient than the approach of buying assets to lower credit spreads. However, unlike with asset purchases, the ability to scale the TALF is constrained by banks' willingness to lend and the ultimate end demand for borrowing.

William Knapp, MainStay Investments

In its statement released Wednesday, the Federal Open Market Committee announced an increased purchase of housing agency debt and will begin the purchase of longer-dated Treasury securities. Up to $300 billion in Treasuries will be purchased in the next six months. This represents about 25% of expected issuance by the government over this period. The New York Fed indicated the purchases would be concentrated in the two- to 10-year maturity range.

The Fed's Fannie and Freddie debt acquisition targets will be raised from last November's levels of $500 billion in mortgage-backed securities and $100 billion in direct agency debt. About $200 billion has been bought to date. The facility was expanded to $1.25 trillion and $200 billion, respectively.

The Fed's aim is to lower borrowing costs, in particular mortgage rates. The Treasury market responded positively to the Fed move as bond prices rose across the yield curve. Rates, which move in the opposite direction of prices, fell. For instance, the 10-year Treasury yield declined half of a percent, to almost 2.5%.

The knock-on effect of lower Treasury yields should be lower borrowing rates for businesses and consumers. Lower business rates make investment more profitable. Lower consumer rates will help revitalize the moribund housing and auto markets. Mortgage rates quickly shed about a quarter of a percent post the Fed announcement.

Tony Crescenzi, Miller Tabak

Results of the Philadelphia Fed's Business Outlook Survey [released Mar. 19] were better than expected, although they remained the poor area. The survey's index on general business conditions increased to -35.0 from -41.3 in February, which was 4 points better than expected. The index has been between -24.3 (January) and -41.3 (February) over the past six months. Readings below zero indicate that a majority of respondents rated conditions negatively. A turnaround in factory activity will likely lag stabilization in demand, as factory inventories have increased sharply in recent months.

That said, cutbacks in industrial output have been severe and are now exceeding the decline in demand, which will reduce inventories faster and hasten stabilization in factory activity. To wit, note that the inventory component within today's release plummeted to a record low of -55.6, from -24.3 in February, breaking the previous low of -50.7 set in March 1975. In addition to the inventory drawdown, the combination of the TALF, fiscal stimulus, the Fed's asset purchase program, and the public-private investment fund (PPIF) will likely underpin demand and make the first quarter the worst for the economic recession.

David Wyss, Standard & Poor's

The March baseline forecast is for the recession to be the deepest and the longest since the Great Depression, with a sluggish recovery beginning in the fourth quarter of 2009. Although lower oil prices have relieved the squeeze on consumers, financial markets have tightened much more than anticipated. The inability to borrow money has pushed investment down more than expected, while consumers suffer from both the loss of wealth and the increased difficulty of borrowing. Although the underlying problems that led to the recession are in some ways similar to those of the 1991-92 recession (during which GDP fell only 1.2% from peak to trough), we think that the financial problems will make the recession much deeper.

The cyclical peak of the latest expansion was December 2007, and the trough is likely to come in the third quarter of 2009. This 21-month recession would be longer than the average of 10.7 months during recessions since the 1950s, and longer than the longest recessions—1975 and 1982 (both at 16 months). We're forecasting negative GDP growth from the third quarter of 2008 through the third quarter of 2009, with a total decline of 3.9%. The stimulus package will boost the economy late in the year, but private-sector demand will remain soft.

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