Regional President Speech

Oce of the President Money Museum Last Updated: 112509 The Economic Outlook and the Role of Credit Intermediation Chartered Financial Analysts Society of Chicago Lunch Mid-America Club 200 East Randolph Street Chicago, Illinois Introduction I am delighted to be here today to share my thoughts about the economy and the nancial circumstances we are currently facing Though I have been president for only six months, I have had the extremely useful experience of attending Federal Open Market Committee meetings since 1995 — rst, as a senior staer, and since 2003, as the Bank's research director Last September, as a newly installed Fed president, I was certainly looking forward with great anticipation to contributing to the discussion of monetary policy at the FOMC meetings Considering everything that has happened since last summer, the safest comment I can make about this experience is, it's been everything I expected — and more Today, I would like to share my thoughts on the state of the economy and the uncertainties over the outlook I will be giving particular attention to the eects that a number of unusual and complex asset valuation issues may be having on the nancial conditions faced by households and rms As always, my remarks this afternoon represent my own opinions, and do not necessarily reect the views of my colleagues on the Federal Open Market Committee or those of the Federal Reserve System Review of the Current Economic Situation Overall, the US economy grew at a solid pace in 2006 and over the rst three quarters of 2007 Real GDP rose at an average annual rate of 2-34 percent over this period — which is a bit above my assessment of the economy's long-run sustainable rate of growth This gain was achieved despite a plunge in residential construction, which reduced growth by an average of 08 percentage points over this period Overall GDP growth remained healthy because the rest of the economy was performing quite well: Business xed investment and household consumption rose at solid rates, and the trade decit fell, led by robust increases in exports This resilience of overall economic growth in the face of signicant sectoral challenges is part of a long-running story Since the mid-1980s, the US has been in the midst of what economists call the Great Moderation, in which uctuations in overall GDP and ination have been smaller than they were over the previous 40 years Improvements in productivity, better policy, and some good luck appear to have made aggregate activity more resilient to the shocks that have hit individual sectors of the economy But that resilience continues to be challenged by new developments Today we are faced with the challenges presented by the recent turmoil in nancial markets By now, this story is familiar to most in the room, but it bears repeating because of its importance The underpinnings for this shock began to form earlier in this decade with the rapid expansion of the subprime mortgage market Most of these mortgages were sold by their originators to nancial entities that bundled them together in mortgage- backed securities In turn, these securities were restructured into a variety of new securities or used as collateral for other nancial instruments At their most complex levels, the income ows from monthly subprime mortgage payments supported many layers of highly structured securities that were held by a wide range of investors Of course, such complex nancial engineering was not limited to subprime mortgages, but was used to securitize a wide range of lending activities Historically, subprime mortgages had experienced relatively modest default rates, even during the 2001 recession However, by mid-decade we now know that underwriting standards had become lax and that originations had expanded signicantly Then, in 2006 and 2007, housing markets began to deteriorate and delinquencies and defaults on subprime mortgages increased substantially As this continued, it became clear that the payment ows on these mortgages would be insucient to meet obligations to the owners of some bonds and downstream structured securities Even the highly rated tranches of subprime- related securities turned out to be riskier than investors had thought at the time they were issued In the summer of 2007, a growing number of market participants began to realize the negative implications that these defaults had for the value of subprime-backed debt instruments Many investors also began to question if they had underestimated the risk of other complex securities, whether they contained subprime-related debt or not This situation was complicated by the fact that many of these securities had been purchased by special purpose nancial institutions that had raised the necessary funds through short-term borrowing in the commercial paper market These institutions had diculty rolling over this paper at existing terms Investors demanded shorter maturities and higher risk premiums to compensate for uncertainty over the valuation of collateral, potential needs for liquidity, and counterparty risks Liquidity became scarce — as evidenced, for example, by large increases in spreads between overnight and term nancing rates These nancial challenges began to weigh noticeably on the economy as we went through the fourth quarter A number of monthly indicators pointed to a slowdown in the pace of growth Notably, housing fell sharply further in November and December In part, this reected fallout from the nancial turmoil: Lenders shied away almost completely from originating subprime mortgages; markets also backed o securitizing any mortgage other than those eligible for issuance by government- sponsored agencies This raised the relative costs of obtaining a jumbo mortgage, even for well-qualied buyers In addition, labor markets softened — hiring slowed and the unemployment rate rose Labor income is the most important factor supporting household consumption, and while the level of consumer spending did increase last quarter, it did so at a relatively modest pace In assessing the extent of the current slowdown, I nd it useful to look at an index we developed at the Chicago Fed in 2000 to summarize the information in a large number of monthly indicators of economic activity The index is the Chicago Fed National Activity Index, or CFNAI An index value of zero is consistent with trend growth in overall GDP The three-month moving average of the CFNAI fell to -067 in December A study I did back in 2002 suggests that readings like this indicate a greater than 50 percent probability that the economy is in a recession Although there are reasons to discount this likelihood somewhat, it is clear that the US economy currently faces substantial headwinds In spite of these headwinds, the economy did record positive but very low growth in the fourth quarter of 2007 Real GDP inched up at a 06 percent annual rate For the rst quarter of 2008, we have only limited data in hand, but much of these data have been disappointing Payroll employment edged down in January, motor vehicle sales fell, and some measures of business activity were quite weak However, some indicators have been a touch more positive For example, retail sales posted a modest increase in January, and the forward-looking data on orders for capital goods ended last year on a positive note In nancial markets, the unusual liquidity pressures have receded some since the turn of the year Some of the earlier pressure reected nancial rms' desire to show very liquid balance sheets on their end-of-year nancial statements In addition, central banks made special eorts to provide liquidity to the nancial system On the Fed's part, we cut the federal funds rate, our principal policy tool, and also lowered the cost and lengthened the maturity at which banks can borrow from us at the discount window Furthermore, we instituted a new Term Auction Credit Facility to augment regular borrowing at the discount window However, despite the improvement in liquidity, overall credit conditions are still strained, and the lending environment is much less receptive to risk-taking than it was prior to last August So we are in the midst of a period of soft economic activity We also are in a period of heightened uncertainty about the economic outlook The Role of Credit Intermediation This uncertainty stems from the inherent diculty in gauging the eects of adjustments in the nancial sector on the spending capacity of households and rms One reason it is so dicult is that the degree of nancial turmoil we have experienced over the past few months is a relatively rare occurrence in the modern US economy We just do not have much historical precedent to go on Nevertheless, we do know that when nancial stress emerges, we must think more thoroughly about the role of credit intermediation in the economy As a general principle, diculties in the credit intermediation process can arise from several sources I rst want to focus on a source that is a particularly relevant issue for the situation today — that is, the eects of an erosion in the value of assets Asset devaluation reduces both the ease with which borrowers can borrow and the capacity of lenders to lend In turn, this can decrease the ow of credit from savers to spenders, resulting in a reduction in economic activity The rst assets to consider are houses The declines in house prices we have experienced reduce housing equity and erode the collateral value of a home against the original loan Housing-backed loans are now riskier, and so the costs and terms of such borrowing have become more restrictive A number of asset valuation issues weigh on the nancial sectors' lending capacity The lower income ows and the drop in valuations for subprime-related securities reduce the ability of such assets to service existing structured debt securities or to support new liabilities aimed at expanding lending capacity In addition, both for regulatory reasons and to signal their soundness to investors, lenders seek to maintain a certain minimum ratio of capital to assets These ratios have been under stress for a number of reasons Losses on subprime-related assets and other securities directly reduce equity capital In addition, for legal or reputational purposes, some banks were forced to take assets held by stressed special purpose vehicles back onto their balance sheets at a loss They also found themselves holding loans associated with leveraged buyouts that they were unable to sell Restoring capital ratios requires that lenders either raise new equity, sell assets, or cut back on new lending Selling assets or reducing lending could have adverse eects on the real economy Fortunately, a number of large banks have successfully raised new capital, with some of the most publicized deals involving investments from sovereign wealth funds These infusions will help buer the impact of balance-sheet adjustments on bank lending Furthermore, the reduced availability of bank loans may be at least partially oset by increased nancing from nonbank lenders, such as insurance companies, hedge funds, and private equity funds And some high-quality nonnancial rms have raised substantial funds on the corporate bond market Indeed, in the recent survey of purchasing managers in nonmanufacturing business, despite a very weak reading on overall activity, only 15 percent of the respondents thought that nancial turmoil was hampering their ability to obtain nancing A second intermediation-related issue revolves around how much the cost of credit has increased One fallout we have seen from the credit diculties is a reduced appetite for funding risky investment projects Lenders are demanding greater compensation for risk, and this has resulted in an increase in the price of credit to many households and nonnancial businesses For example, in the Fed's January survey of senior loan ocers, there was a notable increase in the number of banks reporting tighter standards and increased spreads on loans to both households and businesses Risk premiums on corporate bonds, particularly those below investment grade, have increased noticeably, and issuance of high-yield bonds is down a good deal Similar increases in risk premiums have been seen in the secondary markets for higher-risk bank loans and commercial mortgage-backed real estate To be sure, some of the increase in risk spreads and tighter lending terms represents a typical response to heightened concerns over the macroeconomy as opposed to atypical eects from the intermediation problems And some of the increase is likely a healthy return to more prudent risk-pricing In addition, the cost of funds has fallen for many low-risk borrowers owing to interest rate declines since August Monetary policy actions have lowered the federal funds rate 225 basis points; the 30-year conforming mortgage rate has dropped about 100 basis points to 57 percent; and rates on investment grade corporate bonds also are down A third issue is the potential for asset-related credit intermediation problems to generate a self-reinforcing dynamic that harms the economy The process of selling assets — whether those repossessed in defaults or those that a nancial institution sells to restore its capital position — increases the supply of such assets on the market This can lead to additional erosion of asset values, further cutbacks in borrowing and lending capacity, and broader softness in spending by households and businesses Such a downward spiral could have a serious impact on the macroeconomy The FRB-Chicago Outlook Taking all of this into consideration, our outlook at the Chicago Fed is for real GDP to increase in the rst half of the year, but at a very sluggish rate However, we expect growth will pick up to near potential by late in the year and continue at or a bit above this pace in 2009 This outlook takes into account a large number of unusual factors holding back activity The large overhang of unsold homes will continue to restrain residential investment Greater caution on the part of businesses and consumers will likely limit increases in their discretionary expenditures And the strains on credit intermediation and nancial balance sheets will likely hold down growth to a degree for some time Since these nancial issues are being worked out against the backdrop of a soft economy, we also have to recognize the risk that interactions between the two might reinforce the weakness in the economy In response to these downside inuences, and with ination expectations contained, I believe a relatively accommodative monetary policy is appropriate At 3 percent, the current federal funds rate is relatively accommodative and should support stronger growth Indeed, because monetary policy works with a lag, the eects of last fall's rate cuts are probably just being felt, while the cumulative declines should do more to promote growth as we move through the year In addition, the scal stimulus bill the President signed yesterday will likely boost spending in the second half of the year The economy's inherent resiliency and internal adjustment mechanisms also will work to support growth In the current situation, this adjustment importantly includes the work the nancial sector is doing in "price discovery," that is, the process of determining the proper valuation of the assets they hold in light of reevaluations of their expected cash ows and risks to these ows In addition, intermediaries will do more work in restoring their balance sheets Together, these activities will eventually reduce the drag from the lending and credit channels on the real economy Another part of the internal adjustment process centers on housing As house prices fall, more buyers will nd it worthwhile to enter the market Eventually, price adjustments will stabilize supply and demand, and the drag from residential construction on the economy will subside Finally, there is productivity Productivity is the fundamental determinant to growth in the longer run — it determines how we can turn labor and capital inputs into the goods and services we consume and invest The good news here is that, while it is not as robust as it was in the late 1990s and early this decade, the underlying trend in productivity in the US economy is still solid This trend provides a sound base for production and income generation to move forward over the longer haul Although most of the recent concern about the US economy has been focused on growth, we must also be mindful of inationary pressures The recent news here has been somewhat disappointing We have experienced large increases in food and energy prices, and other commodity prices are high; in addition, we are hearing numerous anecdotes of rms passing on cost increases to their downstream customers The recent numbers on core ination — that is, ination excluding food and energy — also have moved up some over the past several months Core PCE ination is now at 22 percent, a higher rate than I would like to see in the long run I want to emphasize here that, while we often talk about ination in terms of the core measure, we are concerned about maintaining purchasing power over all of the goods and services consumed by households Accordingly, our goal of price stability must be dened in terms of total ination Traditionally, we have found it useful to concentrate on the core measure because it gave us a less noisy reading of longer-run trends in ination; in turn, this reected the tendency for food and energy prices to be volatile in the short run, but to generally average out to the same as core over the medium term However, if outsized increases in food and energy prices persist, then core becomes a less useful medium-term guide to ination trends Furthermore, persistent food and energy price increases will nd their way into ination expectations, which in turn would boost core measures So the recent developments in food and energy prices are a concern that deserve careful monitoring That said, our forecast is for ination to moderate over the next two years Slower growth in 2008 will limit price increases somewhat Furthermore, futures markets point to a peaking of energy and commodity prices However, they have pointed to lower energy prices for some time now, so we do not want to take too much comfort in their current predictions Importantly, ination expectations appear to be contained If households and businesses expect ination to be very low over the longer run, they will not build automatic wage and price increases into their plans, helping to keep actual increases in check Conclusion To conclude, I think it is important to remember that the Federal Reserve has a dual mandate — working to foster nancial conditions that help the economy obtain maximum sustainable employment and price stability As the Committee noted in the policy statement following the January FOMC meeting, though downside risks to growth remain, we think the policy actions taken in January, in combination with earlier moves, should help promote moderate growth over time and mitigate the risks to economic activity We also expect that ination will moderate over time Looking ahead, my policy views will depend on the evolution of these risks, as well as how developments inuence the price stability component of our dual mandate over the medium term Note: Opinions expressed in this article are those of Charles L Evans and do not necessarily reect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System

Charles L. Evans (2008, February 13). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20080214_charles_l_evans

@misc{wtfs_regional_speeche_20080214_charles_l_evans,
  author = {Charles L. Evans},
  title = {Regional President Speech},
  year = {2008},
  month = {Feb},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20080214_charles_l_evans},
  note = {Retrieved via When the Fed Speaks corpus}
}