Actions will lead to future inflationary condition

These past two weeks have been extraordinary in that the Federal Reserve has had to take actions that have not been used since the Great Depression and a few that heretofore have never been used.

There have been several crises in the capital markets that lead us to comment on what they appear to mean. During the last year, we have conveyed a growing concern, through several prior commentaries, as to the dangers and implications of an absence of fear toward various types of increasing risks in our financial system. We believe the culmination of these risks forced the Federal Reserve to take the recent extraordinary actions of creating two new lending facilities for primary dealers and facilitating a merger of Bear StearnsBear-Stearns-Troubles with JPMorganChase to prevent a liquidity and solvency crisis from potentially toppling the U.S. capital markets. The partners of First Pacific Advisors, LLC (FPA) discussed these events on

March 21 and came to several conclusions about what the long-term implications of these actions might be and we will share them with you in this commentary. Fortunately, over the last two years, our preparations for potential financial market disruptions have meant that FPA and most of our product areas have essentially avoided the calamitous effects of this credit crisis.

We have been in disagreement with the Federal Reserve’s policy actions since this credit crisis began. In FPA New Income’s September 2007 shareholder letter, we argued that future Fed policy actions, the lowering of the Federal Funds rate, may prove rather ineffective in dealing with the unfolding credit crisis. The Fed proceeded under the assumption that this was a liquidity crisis, whereby lowering the Fed Funds rate would resolve the credit problems and return stability to the capital markets. However, with each lowering of the Fed Funds rate, there appeared to be very few positive responses from the U.S. capital markets. Even with a record 125 basis point cut in the Fed Funds rate between January 22 and January 30, liquidity and stability in the financial markets did not return by any appreciable degree.

As the Fed Funds rate declined, a growing flight to quality, as reflected by the rush into Treasury securities and away from any security that might have credit risk, began to take hold.

Despite the decline in Treasury interest rates, these declines did not spread to other areas of the capital markets, as exemplified by the 30-year Agency mortgage-backed securities market, where yields rose while Treasury yields declined. At one point, FNMA and Freddie Mac yield spreads increased to over 300 basis points above the Treasury curve versus a more normal 150 basis point spread. Our capital markets were shutting down since participants did not trust the counter parties with whom they were trading.