Tuesday, August 28, 2007

FOMC minutes 

I have just read the FOMC minutes of the meeting of August 7, with an eye towards finding what it was they thought of the subprime market and credit conditions at the time of the meeting. (We won't hear what they thought in their videoconference of August 17, when they cut the discount rate, until October 9.) I read them to say the Fed did not believe the problem had spread by that time out of the subprime market. Moreover, the prime markets looked stable. They saw some issues with asset-based commercial paper and jumbo mortgages, but they get barely more than a mention. In short, while aware there was a potential problem, there was nothing in here that indicates they thought the problem sufficiently severe to overcome lingering doubts that inflation had moderated over the medium term. The inflation readings in early summer, they thought, were due to transitory factors.

Here are some snips:

Demand for housing in the second quarter was restrained by higher interest rates and by tightening credit conditions in the subprime mortgage market. Sales of new and existing homes in the second quarter were down substantially from their average levels in the second half of 2006. In June, single-family housing starts held steady at their May rate, although adjusted permit issuance slipped further. The combination of decreased sales and unchanged production left inventories of new homes for sale still elevated. House-price appreciation continued to slow, with some measures again showing declines in home values.

Outlays for nonresidential construction rose rapidly in the second quarter...

Market participants had largely anticipated the FOMC's decision at its June meeting to leave the target for the federal funds rate unchanged, although the accompanying statement expressed greater concern about inflation than investors reportedly had foreseen and caused the expected path for the federal funds rate to edge higher. Expectations for a policy easing diminished somewhat more in the wake of favorable economic news early in the period. Subsequently, the semiannual Monetary Policy Report to the Congress and the accompanying testimony, which reported lower projections for real GDP growth than investors apparently expected, appeared to prompt a downward shift in investors' expected path for the federal funds rate. Later in the intermeeting period, growing apprehension that turmoil in markets for subprime mortgages and some low-rated corporate debt might have adverse effects on economic growth led investors to mark down their expectations for the future path of policy considerably further. At the same time, measures of long-horizon inflation compensation based on inflation-indexed Treasury securities edged down.

Financial market conditions were volatile during the intermeeting period, particularly over the last few weeks of the interval. Yields on nominal Treasury securities fell on balance, possibly reflecting an increased preference by investors for safe assets as well as revisions in policy expectations. Conditions in markets for subprime mortgages and related instruments, including segments of the asset-backed commercial paper market, deteriorated sharply toward the end of the period. Credit conditions for speculative-grade corporate borrowers tightened substantially, as investors pulled back from higher-risk assets. Spreads on speculative-grade bonds increased to near their highest levels in the past four years. A number of high-yield bond and leveraged loan deals intended to finance leveraged buyouts were delayed or restructured, though other high-yield bonds were issued. In contrast, credit conditions for investment-grade businesses and prime households were relatively little affected by the market turbulence. Issuance of investment-grade bonds continued. Yields on investment-grade corporate issues rose relative to yields on Treasury securities, but because yields on Treasuries declined, yields on investment-grade bonds were about unchanged on net. Nonfinancial commercial paper outstanding posted a modest gain in July, while the pace of bank lending to businesses picked up from an already solid clip. Mortgage loans and consumer credit appeared to remain readily available to households with strong balance sheets, although late in the period some evidence pointed to diminishing availability of jumbo mortgages. ...

Participants agreed that the housing sector was apt to remain a drag on growth for some time and represented a significant downside risk to the economic outlook. Indeed, developments in mortgage markets during the intermeeting period suggested that the adjustment in the housing sector could well prove to be both deeper and more prolonged than had seemed likely earlier this year. Participants noted that investors had become much more uncertain about the likely future cash flows from subprime and certain other nontraditional mortgages, and thus about the valuation of securities backed by such mortgages. Consequently, the markets for securities backed by subprime and other non-traditional mortgages had become illiquid, and originations of new subprime mortgages had dropped sharply. While these markets were expected to recover over time, it was anticipated that credit standards for these types of mortgages would be tighter, and interest rates higher relative to rates on conforming mortgages, in the future than in recent years. However, participants also observed that mortgage loans remained readily available to most potential borrowers, and that interest rates on conforming, conventional mortgage loans had declined in recent weeks, providing some support to the housing sector.

...The ongoing adjustment in housing markets likely would exert a restraining influence on overall growth for several more quarters and remained a key source of uncertainty about the outlook. The recent strains in financial markets posed additional downside risks to economic growth. Members expected a return to more normal market conditions, but recognized that the process likely would take some time, particularly in markets related to subprime mortgages. However, a further deterioration in financial conditions could not be ruled out and, to the extent such a development could have an adverse effect on growth prospects, might require a policy response. Policymakers would need to watch the situation carefully. For the present, however, given expectations that the most likely outcome for the economy was continued moderate growth, the upside risks to inflation remained the most significant policy concern.