speeches · February 17, 2009
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 11 30 09
Economic Outlook and Policy Challenges
Rockford Chamber of Commerce
Rockford, IL
Introduction
Good afternoon and thank you for inviting me to speak to you today And thank you, Einar Forsman, President and CEO of
the Rockford Chamber of Commerce , for that kind introduction
Currently, we nd ourselves in the midst of a serious recession—one that appears headed towards an experience more like the
large downturns in the 1970s and 1980s than the moderate contractions of 1990 and 2001 Many manufacturing-intensive
communities, like Rockford, have been particularly hard hit Today I will discuss the events that brought us to this point, the
outlook for the economy, and the policy challenges confronting the Fed during these troubling times I should note that these
are, of course, my own views and not necessarily those of my colleagues in the Federal Reserve System
Background
Over the past 18 months the economy has experienced deteriorating housing markets, large-scale disruptions to our nancial
services industry, and plummeting consumer and business con dence These and related developments have resulted in a
signi cant decline in overall spending and production and a rise in the unemployment rate, particularly over the past six
months All of this has occurred despite aggressive actions by the Federal Reserve, the Treasury, and the Federal Deposit
Insurance Corporation FDIC to address di culties in credit markets and to bolster aggregate demand As you know,
yesterday, the President signed the $787 billion scal stimulus bill And last week, the Treasury recommended new proposals to
deal with the nancial sector problems These actions, I believe, will help in addressing the di culties we face and in moving
us toward nancial stability and economic recovery
These certainly are challenging, if not extraordinary, times 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 re-assessed 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, softening labor markets, and substantial increases in prices for energy and other commodities
These factors contributed to a contraction in gross domestic product GDP beginning in the third quarter of 2008
A series of solvency and liquidity events also occurred during this period Many nancial rms reported severe losses Famous
names like Bear Stearns, Wachovia, Washington Mutual, Merrill Lynch, Lehman Brothers, and American International Group
AIG were on the list Some of these rms appeared unable to survive on their own and were purchased by other nancial
institutions In the case of Bear Stearns, this involved assistance from the Federal Reserve The Federal Reserve and the
Treasury also were able to arrange loans and guarantees to AIG in order to avoid large-scale disruptions in markets that had
exposures to credit default swaps written by AIG In contrast, when Lehman Brothers experienced especially large losses last
September, no sale or loan support could be made at suitable terms As a result, they went into bankruptcy
These developments intensi ed nancial market participants' concerns over the potential losses on a range of assets, as well as
the ability of their counterparties to meet contractual obligations One important sector that was disrupted was the money
market industry Money funds are major suppliers of nancing to commercial paper and other short-term credit markets
Worried over losses, investors in money market funds began making redemptions To meet these, some funds had to liquidate
assets into an already depressed market, further lowering the prices of these instruments
This process resulted in a marked increase in the cost of issuing all but the safest, shortest maturity of debt that usually rolls
through these markets Even highly rated rms have found it more di cult and expensive to obtain nancing Some have been
able to tap bank backup lines of credit But this substitution just pushes the funding 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 standard monetary policy instrument, the federal funds rate Since September 2007, the Federal
Open Market Committee has lowered the target funds rate 525 basis points, bringing it to essentially zero in December of last
year
Although the corresponding injections of broad liquidity helped credit conditions somewhat, it became clear early on that more
had to be done to facilitate market functioning
At rst, we simply made a number of adjustments to make it more attractive for banks to borrow from the discount window—
which is the traditional way the Fed lends overnight to depository institutions
Given the events of 2008—in which all types of institutions faced liquidity shortfalls—the Fed created 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 "
Most of these facilities have been aimed at the functioning of short-term credit markets Some lend to broker-dealers that
engage in securities transactions with the Fed and have a large-scale presence in short-term funding markets such as the repo
market Others provide a liquidity backstop for commercial paper issuers and facilitate the sale in secondary markets of a
number of instruments held by money market funds As such, these facilities are lending at relatively short maturities—
generally not more than 90 days
More recent Fed actions, however, have taken some longer-term assets onto our balance sheet In December, we began
purchasing debt obligations and mortgage-backed securities issued by Fannie Mae, Freddie Mac, and other government-
sponsored enterprises GSEs This initiative will help support the ow of credit and lower borrowing costs in mortgage
markets
Of course, the Federal Reserve has not been alone in dealing with the crisis The FDIC increased deposit insurance limits and
began to o er insurance on some liabilities of eligible depository institutions and nancial holding companies
Congress enacted the Emergency Economic Stabilization Act, which authorized the Treasury Department's Troubled Assets
Relief Program, or TARP This program has so far provided more than $335 billion in capital injections to the nancial
system to support the lending capacity of banks
Last week, Treasury Secretary Geithner outlined the Financial Stability Plan One element of the Plan is to combine public and
private capital in an e ort to value illiquid assets and move them o of banks' balance sheets
We have seen a number of indications that the traditional easing of monetary policy and the nontraditional policy actions are
beginning to help the functioning of credit markets and reduce nancial strains The spreads on the interest rates charged for
interbank lending, and on commercial paper relative to the fed funds rate, have come down appreciably since October
particularly at the one-month maturity More than $150 billion of debt has been issued with FDIC guarantees, facilitating
medium-term funding by eligible nancial institutions And the rates on conforming mortgages relative to Treasury bonds have
declined since the Fed's GSE purchase program was announced
That said, market disruptions clearly remain, and most spreads between private lending rates and comparable-maturity risk-
free government debt are still quite elevated relative to where they were before the crisis Of course, we would not expect
spreads and other lending terms to return to those prevailing shortly before the crisis—a period when risk was clearly
underpriced Nevertheless, current spreads and terms seem to be well above where the "new normal" will end up
Over the longer run, policy actions and the work being done in the private sector to reassess risks and shore up balance sheets
will help move us toward a new benchmark and more stable nancial conditions This will not be an easy process, and it could
take time before nancial markets function in a manner that fully 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
Economic Outlook
As we know only too well, the economy currently is contracting at a disturbing pace Labor markets have deteriorated
signi cantly The unemployment rate was 4 9 percent when the recession started in December 2007; last month it reached 7 6
percent Weak labor markets have held back growth in real incomes, and further declines in the stock-market and home prices
have led to marked reductions in household wealth Slowing foreign activity and the higher dollar are reducing demand for our
exports Although there has been a modest improvement in some credit conditions, overall they still remain tight The more
pessimistic outlook for the economy has reduced everyone's con dence In turn, we've seen a further pullback in risk-taking by
investors, households, and businesses They are particularly reluctant to take on longer-term investment or spending
commitments
Together, these factors have led to sharp drop o s in business investment, industrial production, and household spending
Overall output, as measured by real GDP, fell at a 0 5 percent annual rate in the third quarter of 2008 and then dropped at a
3 8 percent rate in the fourth quarter—moreover, recent data suggest that the revisions will make this gure even worse Last
quarter business xed investment declined at a 19 percent annualized rate, residential investment fell at a 22 4 percent rate,
and consumer spending dropped at a 3 5 percent pace These are very large declines—on par with those experienced during the
recessions of the mid-1970s and early 1980s
The factors that produced the sharp decline in output in the second half of last year are still in play today Although
preliminary data for January were positive for retail sales, there continues to be weakness in housing starts, employment, and
auto sales Consequently, I expect real GDP will fall markedly in the rst half of 2009 I am currently projecting that GDP will
begin to expand later in 2009, but not enough to o set the declines in the rst half of the year In part, this expected pickup
re ects the support from both traditional and nontraditional monetary policies, scal actions already taken to address the
strains in nancial markets, and progress that nancial markets themselves make in working through their di culties In
addition, the new scal stimulus package will boost output However, its full impact is still unclear, and our forecast could need
some recalibration as we gain knowledge on how the package is a ecting the economy Looking out a bit further, I expect the
pace of GDP growth to move back up in the neighborhood of potential as we move through 2010 However, I do not see
growth as being strong enough to make much progress in closing resource gaps 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 have fallen in recent months, and core prices—which exclude the volatile food
and energy categories—have changed little This appreciable reduction in in ationary pressures re ects falling prices for energy
and other commodities, declines in import prices, and the increase in resource slack due to diminished economic activity
Looking ahead, futures markets expect some increase in energy prices However, substantial resource slack and the likelihood
of some moderate reduction in in ation expectations should hold back overall price increases
Consequently, I expect additional slowing in core consumer price in ation in 2009 and a further edging down in 2010 Over
the longer-run, with appropriate monetary policy, I see both overall and core in ation averaging somewhere into the
neighborhood of 2 percent, which is a rate I see as being consistent with price stability That said, there is notable risk that
in ation will remain a good deal below this range in the medium term
Some Perspectives on Policy
I am now going to turn to some broader perspectives on 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
In December the FOMC decided to move the funds rate to near zero and two weeks ago we voted to leave it unchanged With
the fed funds rate near zero, we cannot lower it any further Yet, clearly, the recession, nancial distress, and low in ationary
pressures call for more policy accommodation For the Fed, this means that the Committee will have to focus on other ways to
impart 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 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,
endorsing 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
Another way to increase monetary accommodation is to work to bring down unusual liquidity and risk premia that are raising
private and longer-term borrowing costs As I discussed earlier, the Federal Reserve has already operated in this arena,
adopting a number of nonstandard policies that are providing liquidity support to a range of institutions and markets And, if
necessary, such nontraditional tools can be expanded
In this regard, in November we announced another joint program with the Treasury, called the Term Asset-Backed Securities
Loan Facility, or TALF And last week the Fed announced it is prepared to undertake a substantial expansion of the TALF
Although not yet operational, the TALF should be up and running soon This temporary facility is designed to support the
demand for asset-backed securities by reducing the likelihood that future liquidity needs could force investors to sell into a
depressed market Holders of securities that are bundles of student, consumer, and small businesses loans can borrow from the
TALF, using the securities themselves as collateral Other asset-backed securities, such as commercial mortgage-backed
securities, could also be eligible The terms on these loans are more costly than those seen during more normal times Thus
TALF loans eventually will become unattractive when conditions improve in markets for traditional sources of funding Large
haircuts on the collateral and TARP funds provide the Fed with credit protection on the facility
Another feature of the TALF is that its loans are for three years—medium-term loans that are noticeably longer than at our
other lending facilities So, like our GSE purchases, it can directly a ect interest rates further out on the yield curve
I should also note that, as conditions warrant, we will be expanding existing programs In addition, we are considering the
purchase of longer-term Treasury securities, if evolving circumstances indicate that such transactions would be particularly
e ective in improving conditions in private credit markets
A common question I hear is: "What principles guide the implementation of these new initiatives?"
Let me step back for a minute and discuss these programs at a more conceptual level In a well-functioning nancial system,
arbitrage moves funds across markets and balances out pro t opportunities It thus aligns term and risk-adjusted returns across
markets This is the reason, for example, why our typical moves to lower the short-term risk-free federal funds rate a ect
borrowing rates over a large range of maturity and risk structures In such an environment, we can focus on the size of the
liquidity injection instead of the particular segment of the market in which the injection occurs
But that is not the case today There is abundant evidence that arbitrage opportunities remain unexploited Due to balance-
sheet capacity limitations, or because uncertainty and risk aversion are so much higher than normal, participants are largely
avoiding markets that are undergoing unusual stress For example, many student loan payments are guaranteed by the federal
government Despite the guarantees, liquidity disruptions have all but shut down the auction rate securities markets that
student loan providers had used to obtain a good deal of their funding Subsequently, they have had substantial di culty in
attracting investors to other types of securities backed by student loans
One way of thinking about these developments is that markets have become highly segmented We do not see funds owing in
to take advantage of apparent pro t opportunities with respect to distressed assets Such an action could ease liquidity
pressures in these sectors and help keep some problems from spilling over into solvency concerns
The ip side of this segmentation is that liquidity injections aimed directly at a particular distressed market are less likely to
leak out to other areas The injections thus hold open the possibility of improving that market's functioning a good deal,
seeding its transition to more normal liquidity and risk valuations This is the rationale for why our nontraditional policies
focus on loans and securities that a ect transactions in particular key markets where we see points of stress But a downside is
that markets outside of this segment could experience stress because of the separation
As stressed markets improve, more normal functioning of the nancial system as a whole can be achieved Financial rms will
become more willing to carry on their usual arbitrage activities, and market segmentation will diminish As such, both the need
and e ectiveness of the special programs will diminish
Because segmentation will change dynamically, the e ectiveness and unintended consequences of credit policies can shift over
time and in unexpected ways This highlights the need for careful design and continuous monitoring of these programs
More generally, as economic activity recovers and nancial conditions normalize, the use of nontraditional policy tools and the
size of the Fed's balance sheet will be reduced, and the FOMC will return to its traditional focus on the federal funds rate
Some of this wind-down will occur naturally as market conditions improve, given the particular pricing and maturity design
features of these programs 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 Fortunately, it is most likely that this dismantling would be associated
with better economic and nancial performance
Conclusion
To conclude, the U S economy faces many challenges The Fed has been proactive in addressing market liquidity stresses
during the nancial crisis— rst by using our traditional monetary policy tools and later through our nontraditional lending
facilities Moving forward, we will be vigilant in monitoring the risks to growth and price stability It is also important for us
to continue to collaborate with policymakers throughout government and 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 orts of the private sector to work through its
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 (2009, February 17). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20090218_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20090218_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2009},
month = {Feb},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20090218_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}