Regional President Speech

LASALLE BANK ECONOMIC FORUM Chicago, Illinois November 25, 2002 ..................................................................... Perspectives on the Economy and Banking Let me start by looking at the national economy and the challenges that were faced by monetary policymakers this year. Just three weeks ago, the FOMC reduced its federal funds rate target by 50 basis points, to 11⁄ percent — the 4 actual federal funds rate has not been that low in 41 years. This was our first action to change inter- est rates since last year, when the funds rate target was reduced 11 times — from a high of 61⁄ percent to 13⁄ percent in December 2001. 2 4 While acknowledging the current softness in the economy, the FOMC on November 6 said that with the action to reduce the funds rate target, the risks to the outlook were balanced between economic weakness and inflation. As you know, the economy slipped into recession in March 2001, with real GDP falling during the first three quarters of 2001. Now the National Bureau of Economic Research — the nonprofit organ- ization that is the arbiter of when recessions begin and end — has not yet determined an official end to the recession. But most economists think it ended sometime in late 2001 or early 2002. Indeed, real GDP growth turned positive in last year’s fourth quarter, and continued to rise through the first three quarters of 2002, although growth has been uneven. The recession, which was mild compared with other recessions, was led by sharp cutbacks in capi- tal spending by businesses. At the same time, consumer spending and housing held up quite well. But that meant there was little pent-up household demand. So most forecasts made early this year were expecting the recovery to be relatively modest compared with the robust growth typically seen in the first year of previous economic recoveries. 108 Michael Moskow Speeches 2002 The economic data for the first half of this year generally were consistent with these expectations. Industrial production rose moderately each month from January through July. Payroll employment increased each month from April though August. And as I noted, real GDP increased — with growth averaging about a 3 percent pace so far this year. However, some of the earlier signs of strength started to fade as we moved through the summer and into the fall. • Industrial production fell in each of the last three months. • Payroll employment fell slightly in both September and October. • Light vehicle sales moved down from their lofty levels of July and August. • In addition, most of the anecdotal information we’ve been hearing in recent weeks suggests slower activity. It appears that spending by consumers and businesses alike has been restrained recently by a high degree of uncertainty. Outlook for regional economy BeforeItouch onthese uncertainties, though, I’d like to take a look at conditions here in our region, and how the Midwest economy has been impacted by the slowdown. First, a little perspective. For much of the 1990s, the economy in the region outperformed the nation by some measures. For example, the unemployment rate in the region was below the national rate. Indeed, it is inter- esting to note that over the latter half of the 1990s, the rate of net job creation in the Midwest was only about half that of the nation. But this was not due to a lack of economic vitality. Rather, we were running short of qualified workers to fill job openings. More recently, however, economic activity in the region began to slow before it did in the rest of the nation. Employmentgrowth began to fall off in the region in late 2000, about six months before the nation as a whole. And when job growth here did begin to slow, there was little doubt that it was due to a softening economy. TheMidwest’s unemployment rate rose quickly, and for much of last year it stood above the national average. But as the slowdown spread throughout the economy, trends in our unemployment rates have more or less mirrored the nation’s since late 2001. Much of the recent softness in our labor markets can be traced back to our concentration in manufacturing industries. Manufacturing was one of the first segments of the economy to feel the effects of the slowdown, as the imbalances that developed toward the end of the expansion reduced business demand for capital equipment and inventories. Household spending, on the other hand, has held up relatively well in the District, much as it has in the rest ofthe nation. Although sales recently have softened somewhat, consumers continue to spend on automobiles and appliances, two industries that are vital to the region. Michael Moskow Speeches 2002 109 Buoyed by some of the lowest interest rates in a more than a generation, sales of both new and existing homes have remained remarkably resilient. Realtors and builders throughout the District tell us that residential real estate sales remain at very high, if not record levels. In addition, home price appreciation has been very healthy during this run, helping to keep the market active. At the same time, commercial real estate activity has turned sluggish. Still, we are seeing some major build- ing projects moving forward in our District. Importantly, we have not experienced as large of a rise in vacan- cy rates as some other markets have, such as those where commercial building took off during the boom in the high-tech sector. Of course, the Midwest did not benefit as much from the “new economy” euphoria that some other regions did. But, when the tech bubble burst, we did not feel the pain that those regions felt either. To be sure, the Midwest did not come away completely unscathed. We do have some significant concentrations of high-tech industries in the region — for example, Chicago’s telecommunications sector. But our high-tech industries are integrated and complementary to our diverse economy, not just to other dot.coms. Still, the Midwest economy, like the rest of the nation, has hit somewhat of a soft spot. And the factors con- tributing to that softness are the same as those affecting the nation as a whole. So let’s turn now to the national situation. Uncertainties facing economy At the national level we face a number of uncertainties. For one thing, we are living in a different world than we did before 9-11. In addition to the uncertainty generated by concerns about terrorism, the cost of doing business is now higher, both through increased insurance premiums and the added costs of providing secu- rity and back-up contingencies. And the economy is dealing with accounting improprieties and failures in corporate governance. These scan- dals have added to an already uncertain business climate. They also have raised the cost of financing new investment. This is evident from further increases in risk spreads on corporate borrowing — particularly for lower-grade issues — and lower prices for new equity issues. To be sure, to the extent that markets had been mis-evaluating risks and returns, then investors should be demanding higher premiums. The concern, however, is that they may go overboard. Capitalism cannot thrive without entrepreneurial risk taking. If we are too risk-averse, we will stifle innovation and, with it, our abil- ity to generate continual increases in our standard of living. That said, capitalism also requires a transparent system of laws and regulations that are enforced in a fair manner. So if we find evidence of criminal behavior or fraud in the executive suite, we must root it out and prosecute. Those found guilty must be punished...which in some cases should include jail time. Another source of uncertainty is the fact that we are operating in a world of increased geopolitical risk, with heightened concerns about developments in the Middle East, particularly Iraq. No one knows how these events will play out. 110 Michael Moskow Speeches 2002 All this uncertainty can inhibit activity. Firms may become hesitant to take on capital spending projects or hire permanent workers when the downside risks are more apparent — or if the consequences of such risks appear to have become more serious. Firms may simply decide to hold off doing anything until they feel more certain that the projects will soon start showing positive cash flow. Also, to the extent that uncertainty depresses the stock market, the dent in household wealth can be a negative factor for spending. This high level of uncertainty has been one of the reasons for the slowing in the economy this quarter. In fact, in a recent survey, private-sector forecasters are expecting real GDP to rise at an annual rate of only 1.6 percent in the fourth quarter. So, we’re in a soft patch. Factors supporting economic recovery Nevertheless, not all the indicators are negative. Consumer spending beyond autos, while softer, is still mov- ing forward. Consumer confidence, buoyed by recent gains in the stock market, turned up a bit in early November. And the housing market has remained robust. Furthermore, certain fundamentals are still positive for the economy. First, aggressive inventory control means that stock levels are now very lean. Thus, some further lift from inventory investment can be expected. This would give a temporary boost to growth. But to solidify the expansion, final demand needs to gain a firmer footing. Important to this will be the degree to which busi- ness fixed investment turns around and household spending keeps moving forward. Second, inflation remains low and well contained. This has allowed monetary policy to maintain an accom- modative stance for an extended period of time. This accommodative stance bolsters demand throughout the economy. Furthermore, fiscal policy moves, including last year’s tax legislation and bills signed into law after 9-11 and early this year, also have been stimulative. Third, household incomes continue to rise at a solid pace. Despite the recession and the modest pace of activ- ity early in the recovery, real disposable personal income currently stands about 51⁄ percent higher than it 2 was at the time the recession began. In contrast, if we look back over the past 30 years, real disposable incomes a year and half after the onset of a recession were up only modestly, at best. Finally, real income also has been supported by strong gains in productivity, or output per unit of input. Since the mid-1990s, the rate of productivity growth has been nearly double the pace of the previous 25 years. Furthermore, productivity was unusually well maintained during last year’s downturn, and, on average, it has increased at a remarkably robust pace in recent quarters. We know that there often is a boost to productivity growth in the early stages of recovery, as businesses demand more from their employees and trim fat from their organizations. But the continued high levels of productivity growth that we have experienced recently support the view that took hold in the late 1990s — that a more fundamental positive structural change has occurred. To the extent this is true, it is an extreme- ly positive sign for the U.S. economy. Rapid gains in productivity growth support the growth in incomes and Michael Moskow Speeches 2002 111 profits needed to maintain the economy’s forward momentum. Ultimately, over the long run, it is productiv- ity growth that determines our standard of living. Banking issues in this economy Productivity growth and many of the other economic trends we’ve talked about — capital investment, labor markets, consumer income and spending, and the stock market — all converge to affect your business… commercial banking. I’m going to focus my remarks primarily on community banks, since so many of you come from that segment of the industry. Even with the recession and recent soft spot in the economy, the banking industry has performed very well. Asset quality problems have been primarily concentrated in large syndicated commercial loans at the large banks. Problem loans are still at manageable levels, compared with the banking problems of the early 1990s. In addition, the banking industry’s earnings and capital are much stronger. Banks have benefited from the declining interest rate environment — both directly in their net interest mar- gins and indirectly through high levels of mortgage refinancing activity. This is a favorable environment for funding improvements in risk management and corporate governance. Risk profiles changing It’sclearthat community banks have raised their risk profiles over the past few years in response to develop- ments in the market and competitive pressures. We have seen an increase in loan-to-asset ratios and in tra- ditionallyhigher-risk loans such as commercial real estate lending. These trends have heightened credit risk. Community banks also have acquired more complex investments, with longer maturities and more embed- ded options, which has increased their market risk. On the funding side, community banks have been relying less on traditional core deposits and more on interme- diaries such as the Internet and wholesale funds providers such as the Federal Home Loan Bank system. Banks benefit from having a wider range of funding sources. But these new sources present different types of risk. Finally, community banks have broadened the array of products and services they offer, both through tradi- tional channels and through the Internet. While this has allowed them to serve customers better, it also has heightened operational risk. All of these increases in risk — credit, market, liquidity and operational — need to be matched with improvements in risk management, which is the challenge that all of you face. Many community banks have taken steps to improve their risk management. For example: They are working to improve their management of loan concentrations. Some are stress-testing concentra- tions to determine the effects of possible downside scenarios. They are refining their internal loan-rating systems to provide greater differentiation among loan grades — what’s known as “granularity.” 112 Michael Moskow Speeches 2002 They are enhancing their methodologies for determining the adequacy of loan-loss reserves. For example, they make sure that loss data include more than just the stellar part of the credit cycle. They are improving the robustness of the tools they use to manage market and liquidity risk. And, finally, they are thinking more comprehensively about operational risks in their activities. We applaud these efforts. Importance of governance I believe that the recent scandals involving corporate governance and accounting issues also provide oppor- tunities for important lessons. Headlines have focused primarily on large corporations and several of the largest money-center banks. And the Sarbanes-Oxley Act and other new regulations apply to large, publicly traded firms. Nevertheless, banks of all sizes can and should take a fresh look at their corporate governance practices. Indeed, as a regulated industry, banks already have a head start on compliance. Directors must ask tough, common sense questions and not overly defer to so-called experts. They need to be willing to challenge management where necessary. Directors should continually educate themselves about the business of banking by receiving outside information through reading, attending conferences or bringing in outside advisers. They need to understand their bank’s operations and be aware of red flags across the whole spectrum of risk. Finally, directors have to insure that there is a culture of strong internal controls. This includes revisiting, if necessary, fundamentals such as segregation of duties and mandatory vacation policies. Internal and exter- nal auditors should be truly independent. Internal audit should be structured so that it functions with impar- tiality and is not unduly influenced by line management. External auditors should not rely so heavily on non- audit fees from the bank that their audit independence is sacrificed. The banking industry is in sound financial condition. But we cannot become complacent about this fact. I would encourage you to look for opportunities to continually improve your risk management capabilities and the overall governance practices of your organizations. Iwant to mention here that the Chicago Fed hosts a Community Bank Council that meets twice a year to dis- cuss issues such as these that are relevant to your industry. And I encourage you to contact members of that council to suggest topics or get information on the discussions. Also, in March 2003, we are holding a con- ference on the future of community banking. It features a keynote speech by Mark Olson, currently a Federal Reserve governor and a former community banker. This should be a very interesting conference, and you can get more information about it from our web site. Conclusion Let me conclude now with some final thoughts on the economy… The economy’s road to recovery has turned out to be bumpier than expected, and we’re currently in a soft Michael Moskow Speeches 2002 113 spot. But the low-inflation environment has allowed us to maintain an accomodative monetary policy for some time, and also gave us room to take out some extra “insurance” with the easing action we took earlier this month. While there is a lot of uncertainty about the outlook, we believe that the monetary policy we have put in place will support aggregate demand. Furthermore, the underlying trends in productivity are strong. As a result, we see the economic expansion regaining momentum next year, with growth reaching its potential during 2003. Moreover, the long-term prospects are bright. The U.S. economy has proven itself resilient and dynamic, driven by an entrepreneurial culture, market-based principles and continuing technologi- cal advances. These factors have enhanced the economy’s ability to handle challenges and have laid the foundation for solid non-inflationary growth in the years ahead. 114 Michael Moskow Speeches 2002

Michael Moskow (2002, November 24). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20021125_michael_moskow

@misc{wtfs_regional_speeche_20021125_michael_moskow,
  author = {Michael Moskow},
  title = {Regional President Speech},
  year = {2002},
  month = {Nov},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20021125_michael_moskow},
  note = {Retrieved via When the Fed Speaks corpus}
}