speeches · January 14, 2009
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 12 01 09
Economic Update
Wisconsin Bankers Association
Madison, WI
Introduction
Thank you, Je Mayers president of WisPolitics com, WisBusiness com for that introduction And thanks to the Wisconsin
Bankers Association for inviting me to speak I'm delighted to be here to share my thoughts on the economy during this
challenging period As always, these are my own views and not necessarily those of my colleagues in the Federal Reserve
System
Today we nd ourselves in the midst of a serious recession—one that may end up being more like the large downturns in the
1970s and 1980s than the more moderate contractions of 1990 and 2001 I want to use my time today to discuss brie y how
we got to this point, the outlook going forward, and the policy challenges that will be confronting the Fed as we move through
these troubling times
How did we get here?
Last Friday the Bureau of Labor Statistics reported that the cumulative job loss in December alone was over 550,000 jobs
Since the beginning of the recession in December 2007, 2 6 million jobs have been lost, 1 9 million in the last four months In
December 2007 the unemployment rate was just 4 9 percent; it ended 2008 at 7 2 percent The latest data on household and
business spending are no more encouraging Overall economic activity has declined substantially over the past six months
despite aggressive moves by the Fed that lowered the fed funds rate to near zero and tripled the size of our balance sheet, as
well as major actions by the Treasury and Federal Deposit Insurance Corporation FDIC aimed at addressing di culties in
credit markets
How did we get here?
In 2007 housing prices peaked, mortgage defaults rose, and strains began to appear in the market for securitized mortgages
The problems in mortgages spilled over to other segments of our nancial markets Market participants reassessed risk, and the
prices of many assets declined This cascading process of re-pricing 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
By the spring and summer of 2008, the tightening of credit conditions had begun to weigh on business spending, and by the
fall, household spending was a ected as well Spending was also reduced by the protracted weakness in housing markets,
declines in nancial wealth, and substantial increases in prices for energy and other commodities These factors contributed to
negative gross domestic product GDP growth in the third quarter of 2008
As we moved through last year, many nancial rms began reporting severe losses Some institutions—notably Bear Stearns,
Wachovia, Washington Mutual, and Merrill Lynch—appeared unable to survive on their own and were purchased by large
banks In the case of Bear Stearns, this occurred with assistance from the Fed In the case of Lehman Brothers, the losses were
especially large, and no buyer came forward at suitable terms As a result, Lehman had to declare bankruptcy At about the
same time, American International Group AIG , an important provider of large credit default insurance during this period, was
unable to fund its liabilities The Federal Reserve and the Treasury were able to arrange a package of loans and guarantees for
AIG in order to support the functioning of markets that had important exposures to these credit default swaps and related
instruments
And as we moved through the summer, ongoing developments in the nancial markets dealt a series of blows to market
con dence The problems with such major institutions intensi ed nancial market participants' concerns about the ability of
their counterparties to repay debt Money market mutual funds, important suppliers of funds to short-term credit markets,
were exposed to potentially signi cant losses, and many investors began making withdrawals To meet the redemptions, many
money market funds liquidated assets into an already depressed market 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 have found it more di cult and expensive to obtain short-
term nancing Some of these rms have been able to tap bank backup lines of credit But this substitution just pushes the
money market di culties back into the banking system, squeezing out the ability of banks to make other loans
Actions by the Federal Reserve
In response to these extraordinary events, the Fed has implemented a number of policies aimed at mitigating the problems in
the nancial system and their potential fallout on the rest of the economy
First, the Fed turned to its traditional monetary policy instruments; that is, it reduced the federal funds rate and the discount
rate The rst funds rate cut occurred in September 2007 The initial moves were measured, but they eventually gave way to
more aggressive rate cuts At the last Federal Open Market Committee FOMC meeting, the funds rate was essentially cut to
zero—525 basis points lower than when we began
Although the corresponding injections of liquidity helped credit conditions somewhat, it became clear early on that further and
alternative extensions of central bank liquidity would be necessary to facilitate market functioning
The Fed made a number of substantial changes to the discount window operations since August 2007 to encourage its use as a
source of liquidity: We reduced the spread of the discount rate over the federal funds rate from 100 to 25 basis points; we
increased the maximum maturity of the loans from overnight to 90 days; and we introduced a new facility that provides loans
through auctions to overcome any stigma that was associated with discount window loans As a result, we have seen a large
increase in lending to depository institutions
Early in 2008, new market dysfunctions emerged, such as the collapse of the auction rate security market And then there was
the sudden demise of Bear Stearns 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 nondepository
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 short-term funding markets Subsequently, we have introduced 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 The Fed began to purchase debt obligations and mortgage-backed securities issued by Fannie Mae, Freddie Mac, and
other government-sponsored enterprises This initiative will help support the ow of credit and lower credit costs in mortgage
markets Indeed, we have already seen a notable reduction in the spreads of conforming mortgages to Treasury bonds since the
program has been announced
Of course, the Federal Reserve has not been alone in dealing with the crisis The FDIC increased deposit insurance limits and
put in place special facilities to insure other liabilities of depository institutions Congress enacted the Emergency Economic
Stabilization Act, which authorized the Treasury Department's Troubled Assets Relief Program, or TARP This program has so
1
far provided more than $335 billion in capital injections to the nancial system to support the lending capacity of banks And,
as you are aware, these capital injections are made through the purchase of preferred stock and also include other features that
support the prudent stewardship of taxpayer resources
In another joint program, the Federal Reserve and the Treasury established the Term Asset-Backed Securities Loan Facility, or
TALF This facility is designed to support the demand for asset-backed securities by reducing the likelihood that future liquidity
needs could force holders to sell them into a depressed market Holder of securities that are bundles of student, consumer, and
small businesses loans can borrow from the TALF, using the securities themselves as collateral TARP funds provide credit
protection to the facility
The traditional easing of monetary policy and the nontraditional actions by the Federal Reserve, Treasury, and other
government agencies all are working to support the functioning of credit markets and reduce nancial strains These actions
and the work being done in the private sector to reassess risks and shore up balance sheets will help move us back toward
something resembling nancial stability But this will not be an easy process, and it could take some time before nancial
markets function in a manner that noticeably facilitates the activities of businesses and households Until they do, we will
continue to experience some drag on activity in the non nancial sectors of the economy And as we know too well, spending,
production, and job creation all currently are contracting at a disturbing pace
Economic Outlook
Let's now take a look at these recent developments in overall economic activity as well as the outlook for the next few years
The National Bureau of Economic Research declared the U S economy peaked in December 2007 and subsequently entered
into a recession Overall GDP growth has been choppy, but in the third quarter of 2008, GDP fell at an annual rate of 0 5
percent Most indicators point to a large contraction in economic activity in the fourth quarter, with many private sector
forecasters looking for a drop of 5 percent or more
As I stated at the outset, labor markets have deteriorated signi cantly over the last few months Weak labor markets have held
back growth in real incomes Along with the nancial strains, these factors have led to weak 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
The housing market has continued to deteriorate, with construction, new home sales, and home prices all declining further in
recent months In the business sector, investment in equipment and software continued to contract Weakening foreign activity
and the higher dollar are reducing exports
Over the last several months we've seen a further pullback in risk-taking in nancial markets, spurred in part by the more
pessimistic outlook for economic activity This led to lower equity prices, higher risk spreads, and tighter constraints in credit
markets, all of which fed back into a further decline in real activity
Going forward, rising unemployment, low levels of consumer sentiment, losses in stock market wealth, declining home values,
and restrictive credit conditions are likely to continue to weigh on household spending Business expenditures are also likely to
be held back by a weaker sales outlook and tighter credit conditions Consequently, real GDP is likely to fall sharply in the rst
half of 2009 We expect GDP growth to slowly recover over the remainder of the year, re ecting the support from both
traditional and nontraditional monetary policies, scal policy actions many of which are yet to be enacted , and progress by
the nancial markets in working through their di culties I expect real GDP to decline for 2009 as a whole and to rise at a
pace in the neighborhood of potential growth during 2010 However, this growth will not be strong enough to close the
resource gaps emerging over this period Indeed, the unemployment rate—the main resource gap measure in the labor market—
is likely to rise into 2010
On the in ation front, headline consumer prices declined in recent months, since energy prices fell sharply and increases in
consumer food prices moderated Falling prices for energy and other commodities, declines in import prices, and the increase
in resource utilization slack due to diminished economic activity have resulted in an appreciable reduction in in ationary
pressures These, along with some moderate reductions in in ation expectations, have caused me to reduce my forecasts for
both core and overall personal consumption expenditures PCE in ation I expect core in ation to slow considerably in 2009
and then to edge down further in 2010 My modal forecast is for in ation to level out within the range we generally see as
being consistent with price stability, somewhere between 1-1 2 to 2 percent There is notable risk that in ation will decline
below this range in the medium term We could see more declines in the headline in ation numbers—which includes both food
and energy components—in the near term because of declining energy prices However, I do not currently see much risk of an
outright de ationary episode, that is, a period of sustained declines in the prices for a wide range of goods and services
Some Perspectives on Policy
Let me now turn to the policy picture The traditional monetary policy action used to combat sluggish economic activity is to
lower the fed funds rate This in turn reduces other borrowing rates and thus stimulates aggregate demand At its last meeting,
the FOMC moved the funds rate down very close to zero In doing so, we judged that the bene ts of these low rates in
stimulating demand outweighed the possible adverse e ects the low rates might have on the operations of some banks and
other nancial rms With the fed funds rate now near zero, we cannot lower it any further So, going forward, the Committee
will have to focus on other ways to impart additional monetary stimulus to the economy
One way that monetary policy in uences nancial and economic activity is through the clarity of our intentions and
communications The manner in which the FOMC communicates policy clearly in uences its e ectiveness And expectations of
likely future outcomes, including those for monetary policy, obviously matter for decisions made by households and businesses
today In this vein, at a time when near-term in ation is likely to be lower than usual, having an explicit numerical objective for
in ation could help keep in ation expectations from falling very far Such an anchor on in ation expectations would help
preserve low real in ation-adjusted interest rates
As I discussed earlier, the Federal Reserve has already adopted a number of nonstandard policies that are providing liquidity
support to a range of institutions and markets If credit market functioning does not improve, and if the outlook for economic
activity does not begin to show signs of improvement, it may be necessary to use these nontraditional tools further
For example, it could be useful to purchase signi cant quantities of longer-term securities such as agency debt, agency
mortgage-backed securities, and Treasury securities to reduce borrowing costs for a range of longer-term instruments
Similarly, possible changes in the size and scope of credit facilities would lower the cost of borrowing in particular targeted
markets
Of course, as economic activity recovers and nancial conditions normalize, the use of nontraditional policy tools will have to
be scaled back, the size of the balance sheet and level of excess reserves will have to be reduced, and the FOMC will return to
its traditional focus on the federal funds rate Some of this scaling back will occur naturally as market conditions improve, on
account of how these programs have been designed Still, nancial market participants need to be prepared for the eventual
dismantling of the facilities that have been put in place during the nancial turmoil
Conclusion
To conclude, 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 traditional monetary policy tools and later through our improvised lending
facilities 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 policymakers across the globe
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 its di culties, will eventually help support a recovery in economic growth
Yet, undoubtedly, the greatest challenge we face is the enormous uncertainty of our situation One great feature of being an
economist in Chicago is that we bene t from the wisdom of many distinguished scholars at our local universities An example
of such wisdom is an observation made long ago by Robert Lucas, a Nobel Laureate from the University of Chicago: "As an
advice-giving profession, we economists are in way over our heads " At any time, this is a sobering and humbling thought to
remember Nevertheless, in the current environment, the pursuit of a range of robust policies in the face of large uncertainties
is likely to be most e cacious A good decision-maker can't place all of his or her policy bets on a single hypothesis when the
evidence is still ambiguous
The need to act in the presence of ambiguity and such unusual events certainly adds to our policy and communications
challenges
We need to work very hard to explain the risks that we are facing and the rationale for why we think our policy actions best
address those risks Much digital ink has been spilled in these attempts so far More is on the way If ink were scal stimulus,
we might see a more rapid economic recovery in 2009
Note
1
TARP has provided $250 billion to nancial institutions, $40 billion to AIG, $25 billion to Citigroup, and $20 billion in
other lending to institutions U S Treasury Department, 2009, report, January 12
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 (2009, January 14). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20090115_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20090115_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2009},
month = {Jan},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20090115_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}