The Fed Rolls Out Heavier Liquidity Artillery, and Is Poised to Slash Rates Again

• First, the amounts outstanding in the Term Auction Facility (TAF) will be increased to $100 billion. The auctions on March 10 and March 24 will each be raised to $50 billion—an increase of $20 billion from the amounts announced for these auctions on February 29. The Federal Reserve will increase these auction sizes further if conditions warrant. To provide greater certainty to market participants, the Fed will continue to conduct TAF auctions for at least the next six months, unless evolving market conditions clearly indicate that they are no longer necessary.
• Second, beginning today, the Fed will initiate a series of term repurchase transactions expected total $100 billion. These transactions will be conducted as 28-day term repurchase (RP) agreements, in which primary dealers may elect to deliver as collateral any of the types of securities—Treasuries, agency debt, or agency mortgage-backed securities—that are eligible as collateral in conventional open-market operations. As with the TAF auction sizes, the Fed will increase the sizes of these term repo operations if conditions warrant.

The Federal Reserve also stated that it is in close consultation with foreign central bank counterparts concerning liquidity conditions in markets.

These actions by the Fed are a warranted response to the continuing rapid deterioration in the credit markets. Symptoms of worsening problems include further increases in borrowing spreads on corporate bonds and mortgages, including AAA-rated bonds and prime conventional mortgages. In addition, the market for securitized prime mortgages has effectively seized up, as fears of further declines in home prices have caused investors to pull away in trepidation of potential mark-to-market write-downs. Finally, the normally very sleepy municipal bond market has been broad-sided by the credit contagion, suffering sharp increases in borrowing spreads and numerous failed auctions—impairing a critical funding source for a wide variety of municipal entities.

The Fed is contending with rapidly rising borrowing spreads and still-tightening credit conditions, which are counteracting much of the monetary easing that it has put into the financial system since September. Moreover, the growth of both narrow and broad monetary aggregates has slowed over the past several months—indeed, the narrow M1 aggregate has started declining on a year-over-year basis, completely contradicting the views of some inflation fear-mongers that the Fed is "printing money" in order to reflate the economy.

With the latest February payroll employment numbers showing three consecutive months of declines in private-sector employment, it is now clear that the U.S. economy is in recession. Indicators that Global Insight has been tracking have been pointing in this direction for some time, and a "common sense" interpretation of recent pressures in the economy would have led to the same conclusion.

The Federal Reserve now needs to step up the battle against recession and deflation, and the ramped-up TAF and repo facilities are the latest salvos fired in that direction. The Fed is expected to follow up this action on the liquidity front by cutting the federal funds target by at least an additional 50 basis points, on or before the next meeting of the FOMC on March 18.