speeches · November 20, 2008
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 12 01 09
Discussion on the Current Economy
Economic Club of Indiana
Indianapolis, Ind
Introduction
Thanks to the Economic Club of Indiana for inviting me to speak today I'm delighted to be here to share my thoughts on the
economy during this challenging period I'd like to say a special thank you to Ann Murtlow, who is a member of our Chicago
Fed Board of Directors As a member of the Board, Ann provides us with valuable information on the regional business
outlook and credit conditions This information not only helps us gauge the local economies within the Seventh District, but
also contributes to our understanding of developments in the national economy Ann also supports an important function with
respect to monetary and credit policy—the Directors vote on the setting for the Bank's discount rate, which is what we charge
banks for borrowing from the Fed This is, of course, particularly important during the current economic di culties
Today, I will discuss the recent events in nancial markets and the Federal Reserve's responses to them I will also give you my
take on the current economic outlook As always, these are my own views and not necessarily those of my colleagues in the
Federal Reserve System
Let me begin with the nancial crisis
Early Stages of the Financial Crisis
Over the past year we have witnessed the deteriorating performance of mortgages and a broad array of mortgage-backed
securities—some of which, as you know, are highly structured instruments with opaque risk pro les The problems in
mortgages have spilled over to other segments of our nancial markets Market participants have reassessed the risk pro les of
other complex securities, and the prices of these assets have declined as well This cascading process of re-pricing has had a
detrimental impact on the liquidity and capital positions of a wide range of nancial institutions in the United States and
around the world
The resulting disruptions to nancial markets have made credit more costly and more di cult to obtain for many households
and businesses Banks are reluctant to lend even to one another because of concerns over counterparty risk, the desire to
preserve liquidity, and limited balance sheet capacity This has resulted in large increases between the London interbank o ered
rate, or LIBOR, and the federal funds rate LIBOR, of course, is a common benchmark for the interest rate charged on short-
term interbank lending Many banks set their interest rates on loans to households and businesses as a markup over their cost
of funds, as measured by LIBOR Increases in LIBOR, no doubt, have translated into higher borrowing rates for those of you
operating a business today Before this nancial turmoil began, the 30-day LIBOR rate typically hovered about 10 basis points
above the level of the fed funds rate that would be expected to prevail over the term of the loan Since the summer of 2007 the
spread has risen substantially, averaging about 50 basis points between August 2007 and August 2008, with a couple of spikes
to about 1 percent
Strains on nancial institutions have also spilled over to other markets, like that for commercial paper Because of concerns
over their ability to meet future payments, some nancial services rms have had di culty rolling over commercial paper or
have seen their costs of issuing paper rise substantially These di culties are also a ecting the availability and cost of
commercial paper funding to non nancial rms Non nancial rms often issue commercial paper to fund regular operations
such as meeting payrolls and buying materials In addition, nance companies issue commercial paper to support leasing and to
extend credit to non nancial customers, such as in the provision of car loans and the nancing of inventories
The tightening of credit conditions has weighed on spending by households and businesses Their spending capacity was also
reduced by the protracted weakness in housing markets, along with earlier increases in prices for energy and other
commodities As a result, aggregate economic activity edged down in the third quarter and has since deteriorated to the point
that the U S economy is now clearly in the midst of a substantial downturn
Over the past couple of months, we have witnessed another wave of large-scale disruptions to the nancial services industry
These recent developments re ect a con uence of factors
As we moved through the summer, the nancial system faced increasing di culties owing to further deterioration of the
economy Consumption began to contract noticeably and labor markets declined at an accelerating pace The weakness in
economic activity intensi ed the strains on banks since not only mortgage loans, but also business, car, and credit card loans
started to exhibit higher default risks The deteriorating credit risks led banks to hold on to liquid assets even more and to
tighten credit standards even further
At the same time that the macroeconomic picture was deteriorating, a number of large nancial rms were reporting severe
losses Some institutions—notably Wachovia, Washington Mutual, and Merrill Lynch—appeared unable to survive on their own
and were purchased by large banks However, losses at Lehman Brothers were especially large, a buyer could not be found, and,
consequently Lehman had to declare bankruptcy At almost the same time, American International Group AIG , one of the
most important issuers of credit default insurance, found itself unable to meet its liabilities without a loan from the Federal
Reserve
These developments dealt a serious blow to market con dence The problems in these major institutions intensi ed nancial
market participants' concerns about the ability of their counterparties to repay debt This heightened assessment of risk
resulted in funding becoming even more di cult and expensive to obtain across a spectrum of markets
In the interbank market, LIBOR spreads spiked up again, jumping brie y to as high as 335 basis points This, of course, made
many types of bank loans even more expensive Banks also further tightened their credit standards for new lending to both
businesses and households
In credit markets, concerns about the loss exposure of even normally highly rated rms led to a fall in value of a wide range of
debt instruments and derivative products In commercial paper, this was re ected in a spike in rates for many issues,
particularly those for asset-backed securities and the paper of lower-rated non nancial rms
Furthermore, the problems in the commercial paper and other short-term lending markets continued to spread following the
initial shock In part, this re ected a feedback loop between these markets and the money market mutual funds Money market
funds hold commercial paper and repurchase agreements with highly rated rms Money market mutual funds that held
Lehman or other now-distressed paper were exposed to potentially signi cant losses Indeed, the Reserve Primary Fund, ended
up "breaking the buck," meaning its net asset value per share dropped below $1, after su ering losses on its holdings of Lehman
debt
As a result of such losses, many investors began redeeming funds from money market accounts or shifting funds into Treasury-
only accounts To meet the redemptions, many money market funds had to liquidate assets into an already depressed market In
addition, other commercial paper was downgraded and became ineligible to be purchased by money market mutual funds,
exerting further downward pressure on this market Furthermore, as perceived price risk and redemption risk increased
dramatically, there was a marked reduction in the maturity of commercial paper and other debt being rolled through the
markets
As a consequence of these pressures, even some highly rated rms found it more di cult and expensive to obtain short-term
nancing through the commercial paper and repo markets Some of these rms have been able to tap bank back-up lines of
credit But this substitution just pushes the money market di culties back into the banking system The drawdowns of existing
bank revolvers and credit lines increase the size of banks' balance sheets at a time when they are trying to reduce leverage
Thus, they potentially squeeze out the ability of banks to make other loans This is similar to how the redemptions by the
money market funds' customers reduced the funds' capacity to invest in commercial paper that non nancial rms then use to
fund operations
Actions by the Federal Reserve
The Fed has implemented a number of policy responses to these extraordinary events, aimed at mitigating the problems in the
nancial system and their potential fallout on the spending and production capacity of the rest of the economy
First, the Fed turned to its traditional monetary policy instruments, that is, to reductions in the federal funds and the discount
rate In August 2007, the Fed reduced the spread of the discount rate over the federal funds rate from 100 basis points to 50
basis points; and last March it was reduced further to 25 basis points The rst funds rate cut occurred in September 2007
The initial moves during the fall of 2007 were measured, but eventually gave way to more aggressive rate cuts Today, the
funds rate is 1 percent, 425 basis points lower than when we began
Although the corresponding injections of liquidity into the overnight interbank market have reduced restrictive credit
conditions somewhat, it became clear early on that further and alternative extensions of central bank liquidity would be
necessary to restore adequate interbank lending at term and further facilitate market functioning
Even in normal times, the discount window at the Fed is available to sound depository institutions in order to smooth payment
di culties Such lending can also help the ow of credit in interbank markets more generally, and as early as the fall of 2007,
the Fed made a number of substantial changes to the operation of the window to encourage its use One change was increasing
the maximum term of the loans to up to 90 days; traditionally, borrowing at the window was overnight or very short term
And since these changes have been made, we have seen a large increase in lending to depository institutions
Earlier this year, new market dysfunctions emerged, like the collapse of the auction-rate security market And then the sudden
demise of Bear Sterns last March These episodes clearly indicated that in this strained environment, nancial market
participants other than depository institutions might face liquidity shortfalls that could have serious, far-ranging repercussions
for the economy This led the Fed to create a number of facilities to directly provide liquidity to non-depository institutions;
the Federal Reserve Act grants us such emergency powers when the economy is faced with "unusual and exigent circumstances "
At rst, these measures were aimed at lending to broker-dealers who engage in securities transactions with the Fed and who
have a large-scale presence in the repo and other short-term funding markets Most recently, we have introduced new lending
facilities to help work through the disruptions in the money market mutual fund and commercial paper markets These
programs provide a liquidity backstop for commercial paper and facilitate the sale in secondary markets of a number of
instruments held by money market funds Although it is still early, I am hopeful that these programs will have substantial,
positive e ects on restoring liquidity in the short-term nancing market Indeed, the spreads between commercial paper and
the fed funds rate have fallen, retracing most of the run-up that occurred in mid September
Of course, the Federal Reserve has not been dealing with the crisis in a vacuum Congress also responded by enacting the
Emergency Economic Stabilization Act As part of the act, the Treasury has injected signi cant capital into the banking system
In addition, deposit insurance limits have been increased and the FDIC has put in place special facilities to insure other
liabilities of depository institutions
I believe that together, the actions by the Fed and the other branches of government will help unlock lending capacity and will
move us toward nancial stability But it will not be an easy process, and it could take some time before nancial markets
function in a manner that does not impinge on the activities of businesses and households
Economic Outlook
That brings me to recent developments in the non nancial sectors of the economy, and the outlook for over the next few years
Over the past year, the U S economy has been slowing, and in the third quarter, GDP fell at an annual rate of 0 3 percent
Payrolls, which had been declining slowly since December 2007, fell sharply in September and October, bringing the year-to-
date job losses to 1 2 million There also has been a sharp rise in the unemployment rate—in October, it was 6 5 percent Weak
labor markets and rising consumer prices have held back growth in real incomes These, along with the nancial strains, have
led to marked weakness in business investment, industrial production, and consumer spending Indeed, the declines in
consumer spending over the past few months have been very large—on par with the drops experienced during the 1990 and
1982 recessions
So, currently, aggregate economic activity is contracting At this time it is very di cult to judge how long the downturn might
last and how deep it ultimately will be As nancial markets work through their problems—with important help from
government policy—and credit ows improve, we will see a return of growth in spending, production, and employment But
given the magnitude of the problems that we face, we could see activity remaining quite sluggish through much of 2009
This thinking shaped the forecast that I submitted at our most recent FOMC meeting on October 28th and 29th At that time
the central tendency of the forecasts of the Governors and Reserve Bank Presidents for GDP growth for 2008 as a whole was a
range of 0 to 0 3 percent Given that GDP growth averaged a bit under 2 percent in the rst half of the year—well, you can do
the math—these forecasts imply a noticeable decline in real GDP in the second half of the year
In explaining their forecasts, many participants noted the weakening data on consumer spending, stock market wealth,
consumer con dence, and labor market conditions as well as the severe dislocations in credit markets These factors were
expected to weigh heavily on household and business spending in 2008 and persist to some degree in 2009 Furthermore,
weakness abroad was expected to hold back growth in exports Accordingly, participants were looking for a relatively gradual
recovery, with most of the forecasts for 2009 being somewhere between a 1 4 percent decline and a 1 percent increase in real
GDP The recovery is expected to take hold more rmly in 2010 and 2011
In this growth environment, most forecasts had the unemployment rate rising to between 7 1 and 7 6 percent by the fourth
quarter of 2009 before moving down to between 5-1 2 and 6-1 2 percent by the end of 2011 Such unemployment rates
would mean that a substantial degree of resource slack would remain in the economy over the next few years This slack, along
with the recent declines in the prices of energy and other commodities, should bring down in ation Increases in the price
index for total personal consumption expenditures were projected to fall from the 2-3 4 to 3 percent range in 2008 to
between 1 4 and 1 7 percent in 2011 To me, this outcome would be consistent with price stability
When submitting these forecasts, the Committee members also noted that the degree of uncertainty about the outlook was
unusually high In large part this re ects the wide range of possible outcomes for the nancial crisis and the associated
interactions with the real economy Personally, I thought it was easier to envision the bad-outcome scenarios than the good
ones Most of my colleagues agreed, and so viewed the risks to the forecast as being skewed to the downside
Indeed, since these projections were made, the incoming data, particularly on consumer spending and labor market conditions,
have been weaker than I had expected That said, not all of the news has been bad The prices for energy and other
commodities have come down further And, as I mentioned earlier, we have seen some declines in spreads on interbank
borrowing rates and the commercial paper market I am hopeful that we will see continued improvement in nancial market
functioning and that this will show through in improved credit terms for households and non nancial businesses But, as I
noted earlier, it likely will be a while before markets are functioning in a manner that we would characterize as smooth and
e cient
Conclusion
The U S economy continues to face many challenges The Fed has been proactive in addressing market liquidity stress during
the nancial crisis— rst by using our monetary policy tools and later through our improvised lending facilities in response to
nancial markets Moving forward, it is important that we be vigilant in monitoring the risks to growth, as well as any risks to
the prospects for obtaining price stability It is also important for us to continue to collaborate with global policymakers in the
pursuit of nancial stability worldwide We likely are in for a protracted period of poor economic performance But the policy
actions taken by the Fed and other governmental agencies over the course of the nancial crisis, and the e ort of the private
sector to work through their di culties, will eventually help support a recovery in economic growth
Note: Opinions expressed in this article are those of Charles L Evans and do not necessarily re ect the views of the
Federal Reserve Bank of Chicago or the Federal Reserve System
Cite this document
APA
Charles L. Evans (2008, November 20). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20081121_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20081121_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2008},
month = {Nov},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20081121_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}