speeches · November 6, 2007
Speech
William Poole · President
Market Healing
MarquetteUniversity
Milwaukee,Wisconsin
November7,2007
Anyone who has followed the news at healing.Mydiscussionofthesubprimemortgage
all since early August is well aware marketwillbebriefasthattopicwasthesubject
of disorder in financial markets. This ofaspeechofminethispastJuly.1Thehistoryof
episode is not yet complete. The marketupsetsisvaluableinunderstandingthe
financial turmoil of 2007 will join previous currentsituation;I’lldiscusstwosuchsituations—
market upsets analyzed with such great insight the1987stockmarketcrashandtheoneinitiated
bytheeconomichistorian,CharlesKindleberger. bythe1998Russiandefault—toillustrateissues
His book, Manias, Panics, and Crashes, is an importanttounderstandingthecurrentmarket
indispensable resource describing such episodes upset.I’llfinishbyofferingsomethoughtson
over the past several hundred years. howthehealingprocessworksandtheroleof
Althoughweknowalotaboutmarketupsets, thecentralbank.
relativelylittleworkhasbeendoneonrecoveries Beforeproceeding,Iwanttoemphasizethat
fromthem.Thistopicisclearlyanimportantone theviewsIexpressherearemineanddonot
today—thecurrentepisodeofmarketturmoilis necessarilyreflectofficialpositionsoftheFederal
notyetcompletedandthereforeisnotyetjusta ReserveSystem.Ithankmycolleaguesatthe
matterforeconomichistorians.Policymakersare FederalReserveBankofSt.Louisfortheircom-
watchingcloselyandconsideringwhatadditional ments,especiallyDanielL.Thornton,vicepresi-
policymeasures,ifany,wouldassistthemarket dentintheResearchDivision,whoprovided
healingprocess. specialassistance.However,Iretainfullrespon-
Whenarrivinginformationtriggersafinancial sibilityforerrors.
markettrauma,weknowthatthetraumareflects,
typically,aflighttoqualityasinvestorsreactto
newinformationsuggestingthatcertainassets THE FINANCIAL TURMOIL OF
maybeworthlessthanpreviouslythought.
2007
Marketturmoilsubsidesovertimeasstabilizing
marketforcestakehold,typicallyasinvestors By2006avarietyofindicatorsweresuggest-
searchforbargainsamongassetswithdepressed ingthatthehousingboomwassubsiding.Itwas
prices.Policyresponsescanassistthehealing notyetclear,however,thattheboomwasabub-
process,butitisimportantthatpolicyactions blethatwouldbebursting.Salesofnewsingle-
harnessmarketforcesandnotfurtherdisrupt familyhomes—whichhadincreasedrapidly
them.Overthelongerrun,lessonsfrommarket duringthepreviousfiveyears—begantodecline
turmoilmaysuggestreformstolawsandregula- followingthesalespeakinJuly2005,andthe
tionstoreducetheprobabilityofrecurrence. declinecontinuedthroughout2006.Bytheend
Iwilldiscusstherecenttroublesinthesub- of2006,housingstartshaddroppedtoathree-
primemortgagemarketandevidenceofmarket yearlow.Perhapsmoreominously,during2006
1 SeePoole(2007)foramuchmorecompletediscussionofthesubprimemortgagemarket.
1
FINANCIALMARKETS
themortgageforeclosureratebegantoincrease, todecline,ratesonsuchpaperhadincreased
goingabove0.5percentforthefirsttimeinthe onlyafewbasispointsbeforeAugust9.Buton
nearly35-yearhistoryoftheseries.Contributing August9,AmericanInternationalGroup—oneof
totheproblem,residentialpropertyvaluesbegan thelargestmortgagelendersintheUnitedStates—
todeclineinmanyregionsoftheUnitedStates announcedthatmortgagedefaultswerespreading
and,accordingtothemostrecentlyavailable beyondthesubprimemarket.Thisnewsadded
data,thedeclineiscontinuing.Accordingtothe toconcernsstemmingfromaJuly24announce-
Case-Shiller10-cityhomepriceindex,thefirst mentbyCountrywideFinancialCorporation—
monthshowinga12-monthdeclinewasJanuary thelargestU.S.originatorofmortgagesin2006—
2007,andthatwasthefirstsuchdeclineinmore thatsubprimemortgageproblemshadspreadtoits
thanadecade.2 portfolioofprimemortgages.BetweenAugust8
Byearly2007,evidenceofdifficultiesinthe andSeptember13therateonABCPincreasedby
subprimemortgagemarketbegantoemerge. 84basispoints.WhileABCPrateshaddeclined
BetweenDecember2006andAugust2007scores toearlyAugustlevelsbylateSeptember,thevol-
ofmortgagecompaniesceasedoperations,either umeofoutstandingABCPcontinuedtodecline.
throughbankruptcyorsuspensionofcurrent Ashortdigressionisinorderatthispoint.
activity.Othermortgagecompaniesreported Commercialpaperisashort-termcorporateIOU.
largelossesandsuspendedtheirsubprimemort- Therearethreemaintypesofcommercialpaper—
gagelending.InJune2007,BearStearnspledged issuesbynon-financialfirms,issuesbyfinancial
upto$3.2billiontobailoutahedgefundthat firmssuchasauto-financecompaniesandasset-
madebadbetsinthesubprimemortgagemarket. backedpaper.TheassetsbackingABCPmaybe
Amonthlater,BearStearnsannouncedthattwo subprimemortgages,creditcardreceivables,auto
ofitshedgefundsthatinvestedheavilyinsecu- loansorothersimilarassets.Thematurityof
ritiesbackedbysubprimemortgageshadlostover commercialpaperrangesfromoneto120days.
90percentoftheirvalue.Bothfundsdeclared In2006,forexample,90percentoftheoutstanding
bankruptcyonAugust1. paperhadmaturitiesof40daysorlessandonly
AccordingtoaTreasurydepartmentannual 5percenthadmaturitiesof81daysormore.At
survey,whichwasreleasedinMarch2007,on theendof2006,paperissuedbynon-financial
June30,2006,foreignersheldnearly$1trillion firmswas9.3percentofthetotal,byfinancial
inasset-backedsecurities.Precisedataareunavail- firms37.9percentofthetotal,andABCPwas
able,butaroughguessisthatasofmid-2006for- 53.8percentofthetotal.
eignholdingsofsecuritiesbackedbysubprime Themarketturmoilbeganasinvestorsstarted
mortgageswere$100to150billion.Consequently, tofleeABCP.Itisnormalpracticeforinvestors
problemsintheU.S.subprimemortgagemarket incommercialpapertorollovertheirinvestment
spreadfinancialdisorderworldwide.OnJuly30, inwholeorinpart,dependingontheirownneed
theEuropeanCentralBank(ECB)announced forfunds,butinAugustinvestorswhomight
thatitwasprovidingliquiditysupportforIKB haveroutinelyrolledovertheirinvestmentin
DeutscheIndustriebank,alargeGermanbank, ABCPbeganaskingforredemptionasthepaper
whichhadmadesubstantialinvestmentsinU.S. matured.Moreover,investorstendedtofleeall
mortgage-backedsecurities. typesofcommercialpaperandnotjustpaper
Despiteallthebadnews,broadfinancial backedbysubprimemortgages.Theirunwilling-
marketswereinitiallylittleaffected.Although nesstorollovermaturingpaperputtremendous
thevolumeoftradinginasset-backedcommer- pressureonissuerstofindfundstoredeemmatur-
cialpaper(ABCP)peakedinlateJuneandbegan ingissues.Manyissuersturnedtocommercial
2 TheCase-Shiller20-cityindexisalsodecliningbutthatseriesgoesbackonlyto2000.
2
MarketHealing
banks,drawingonbackuplinesofcredit.Investors Theimpactonfinancialandnon-financial
hadtodosomethingwiththefundsonmaturing commercialpaperwaslessseverebutsignificant.
CP,andtheytendedtobuyshort-termTreasury Thevolumeofnon-financialcommercialpaper
securities.Thus,theflighttoqualitydroveup outstandingdeclinedbynearly15percent,while
theratesonCPanddrovedowntherateson thevolumeoffinancialpaperdeclinedbyabout
Treasuryissues. 5percentfromearlyAugusttomid-October.
Twofigurescanhelptodisplaythescaleof Despitetheimpactonthevolumesofnon-finan-
themarketdisruption.Figure1showsthefederal cialandfinancialcommercialpaperoutstanding,
fundsrateandtheTreasurybillrate.Verticallines theimpactontheratesofthesesecuritieswas
marksomeofthekeyevents.Theextentofcredit relativelymodest.RatesonbothtypesofCP
marketvolatilityisevident.Figure2showswhat remainedneartheirpre-August9leveluntilearly
happenedtothevolumeofcommercialpaper Septemberandthenbegandriftinglower.These
outstanding.Thescaleofthecontractionisobvi- ratesdeclinedbyabout25basispointsfollowing
ous,ascommercial-paperissuershadtoredeem theFOMC’s50-basis-pointcutinthefederalfunds
scoresofbillionsofdollarsworth. ratetargetonSeptember18.
OnAugust9,boththeEuropeanCentralBank Anotherindicationofmarketturmoilwas
andtheFederalReserveinjectedlargeamountsof thatratesoncertificatesofdeposit(CDs)and
liquidityintothefinancialmarket.OnAugust9, EurodollardepositsrosesharplyonAugust9on
theECBinjected€95billionandtheFedinjected newsthatthesubprimeproblemswerespreading
$24billion;subsequently,thetwocentralbanks tothebroadermortgagemarket.CDandEuro-
engagedinfurtherlargeinjectionsoffunds. dollarratesrosebecausebothoftheseassetsare
TheFed’sinjectionsoffundsweredesigned usedbybanksandotherdepositoryinstitutions
tokeepthefederalfundsratenearthetargetrate tosupporttheirloanportfolios.Banks’needfor
setbytheFederalOpenMarketCommittee liquiditydrovetheserateshigher.Bothrates
(FOMC),theFed’smainmonetarypolicybody. declinedwhentheFOMCreduceditstargetfor
However,giventhevolatilemarketsituation,the thefederalfundsrateonSeptember18,butthe
OpenMarketDesktended,appropriately,topro- spreadoftheseratesoverthefundsratetarget
videfundsgenerously.Thefundsratetradedhigh didnotreturntoitspre-crisislevel.
relativetotheFOMC’stargetof5.25percenton Thefinancialturmoilspilledovertorateson
the9thbutdeclinedsharplyonthe10th. bankdepositsinforeigncountries.Thatspread
Anotherindicatorofmarketturmoilwasthe occurredpartlybecauseofthecloserelationship
rateonshort-termTreasurybills.Theserates betweenCDandEurodollardepositratesandsimi-
declinedintheflighttoquality.The1-monthT- larassetsinothercountriesandpartlybecause
billratedeclinedby44basispointsonAugust15 manyinternationalinvestorsheldsecurities
andbyanother105basispointsonAugust16. backedbyU.S.subprimepaper.Depositratesin
OnAugust17,theFedannounceda50-basis- Canada,theUnitedKingdomandtheEuroarea
pointcutinthediscountrate. wereaffectedsimilarlytotheCDandEurodollar
Marketturmoiloriginatedinthemarketfor ratesintheUnitedStates.DanishandJapanese
securitiesbackedbysubprimemortgagesbutthen rateschangedlittleonaverage,butbecamemuch
spreadtofiveimportantmarketsegmentsbeyond morevolatile.
theasset-backedsecuritiesmarket.Thefirstwas Theflighttoqualityhadadramaticeffecton
thecommercial-papermarketmoregenerally. ratesintheU.S.Treasuriesmarket.T-billrates
ThevolumeofABCPoutstanding—muchof declinedrelativetoratesonassetswithdefault
whichwasmortgagebacked—peakedintheweek risk.Theflighttoqualityismostevidentatthe
endingAugust8.Bymid-October,theoutstanding shorterendoftheyieldcurve.Theflighttoqual-
volumehaddeclinedby$281billion,ornearly ityatthelonger-endoftheyieldcurveoccurred
25percent. earlier.ThespreadbetweencorporateAAAbonds
3
FINANCIALMARKETS
Figure 1
Figures
Subprime Crisis: Funds Rate and Funds Rate Target
Figure 2
Total Outstanding Commercial Paper (s.a.)
4
MarketHealing
andBBBbondsoverthe10-yearTreasuryyield manner.TheFedpromotesfinancial-marketeffi-
widenedsignificantlyinmid-July.TheAAA ciencythroughvariousregulatorymeasuresand
spreadhadbeenabout60basispointsandthe byprovidingthemarketswithampleliquidityin
BBBspreadabout120basispoints,butthetwo timesofstress.
spreadswidenedtoabout75and165basispoints, Mostofthetime,financialmarketsarehighly
respectively,andhavefluctuatedinawiderange efficient.TheFed’sroleistoconductmonetary
aroundtheselevelssincethen. policyeffectivelyinpursuitoftheobjectivesof
Thedisorderalsoshowedupinthefederal priceandemploymentstability.TheFedtriesto
fundsmarket,asisevidentinFigure1.Thefunds conductopenmarketoperationswithasmuch
ratespikedabovetheFOMC’stargetof5.25per- regularityandpredictabilityaspossible,topro-
centonAugust9andthenfellbelowthetarget videastablebaseformarketstotradeawide
thefollowingday.Giventhemarketdisruption, rangeoffinancialassetsefficiently.
theFed’sOpenMarketDesksuppliedreserves Onoccasion,however,eventsdisruptnor-
liberally,andthefundsrateremainedbelowthe malmarketprocessesandspecialFedactionis
targetuntilSeptember14,theFridaybeforethe helpful.ThemajorrolefortheFedhereistosee
FOMCreducedthetargetfrom5.25to4.75per- thatthereisadequateliquidityintimesofuncer-
centonSeptember18.Thefundsratehastraded taintyandtoprovideadditionalshort-termliquid-
aroundthetargetsincethen,butinawiderband itywhenthereisalegitimateneedforit.There
andismorevolatilethanitwasbeforeAugust9. arenumerousinstanceswhentheFedhaspro-
Icansummarizekeyfeaturesofthemarket videdextraliquidity.Themostdramaticexample
upsetthisway.Theturmoilbeganwithdisclosure istheattackontheWorldTradeCenter,whenthe
oflargelossesonsecuritiesbackedbysubprime Fedinjectedasmuchas$140billionforafew
mortgages.Commercial-paperinvestorsbeganto
daystosupportfinancialmarkettransactions.A
fleeasset-backedcommercialpaper,puttingtheir
muchlesswell-knownexampleisthattheFederal
fundsinsteadintosafeassets,especiallyTreasury
ReserveBankofNewYorkadvancedtheBankof
securities.Companiesthathadreliedonfunding
NewYork$22.6billionovernightonNovember21,
theirassetsbyissuingcommercialpaperwere
1985,becauseofacomputersoftwarefailureat
stressedtocomeupwithfundstoredeemmatur-
theBankofNewYork.Theliquiditysuppliedin
ingpaper.Theyturnedtoacombinationofasset
August2007throughopenmarketoperationsand
sales,whichputdownwardpressureoncertain
thediscountwindowisjustthelatestexample
assetprices,andtobankloans,whichputpres-
oftheFedsupplyingshort-termliquiditytosup-
sureonbankstofindthefundstofulfilltheir
portfinancialmarketsinunusualcircumstances.
commitmentstoprovidebackupcredittocom-
Therearetimeswhenprovidingadditional
mercial-paperissuers.Theflighttoqualitywas
liquidityiseitherunnecessaryorinadequate.A
sointensethatmanyinvestorsinitiallyturned
dramaticexampleofsuchatimeisthestock
awayfromallcommercialpaper,whetherbacked
marketcrashon“blackMonday,”October19,
bysubprimemortgageassetsornot.
1987.BeforethemarketsopenedonOctober20,
theFedannouncedthat,“TheFederalReserve,
consistentwithitsresponsibilitiesastheNation’s
ROLE OF THE FED
centralbank,affirmedtodayitsreadinessto
TheFed’sobjectiveistopromotemaximum serveasasourceofliquiditytosupporttheeco-
sustainableeconomicgrowthbyfosteringprice nomicandfinancialsystem.”TheFedmadeclear
stabilityandminimizing,totheextentpossible, thatdepositoryinstitutionscouldavailthemselves
fluctuationsinemployment.TheFedcancon- ofthediscountwindowasneeded,eventhough
tributetotheseobjectivesbyhelpingfinancial doingsomightnotmeetalltheusualadminis-
marketstooperateinanorderlyandefficient trativerequirementsthenineffect.
5
FINANCIALMARKETS
ItwasimportantfortheFedtomakeclearto Thespreadrosefurtherto114basispointson
banksthatdiscountwindowfundswereavailable. September23,whentheFederalReserveBankof
However,fewbanksactuallyborrowed.Before NewYorkhelpedorganizearescuepackagefor
thecrash,borrowingduringtheweekending LTCM.Bythattime,LTCM’sequityhaddeclined
October15averaged$1.147billion;fortheweek bynearly90percent.Therescuepackagecon-
endingOctober22,averageborrowingwasonly sistedofacapitalinfusionbyseveralinvestment
$219millionhigher.Liquidityturnedoutnotto banks.Inreturn,theparticipatingbanksgota90
beanissue. percentshareinthefundandapromisethata
Concernsthatthestockmarketcrashmight supervisoryboardwouldbeestablished.
spreadtotheeconomymoregenerallyandaffect In1998,theeconomywasexperiencing
economicgrowthpromptedtheFOMCtoreduce stronggrowthandinflationwaswellcontained.
itstargetforthefederalfundsrateby50basis Inthisenvironment,concernsthattheeffectsof
theRussiandefaultmightspreadtotherealecon-
pointsonNovember4,1987.TheFOMCcutthe
omypromptedtheFOMCtoreducethefunds
targetfedfundsratedespitethefactthatinflation
ratetargetby75basispoints,inthreestepsof25
wasrunningatanunacceptablyhighrateofover
basispointseach,betweenSeptember29and
4percent.TheFOMCreducedthetargetbyan
November17.
additional30basispointsbyFebruary11,1988.3
In1999,aseconomicgrowthremainedstrong
Oncethecrisishadpassed,theFOMCbeganrais-
andinflationpressuresbegantorise,theFOMC
ingthetargetfedfundsrate.ByMay1988thetar-
beganreversingitsactions.Bymid-November
getwasonlyslightlybelowitspre-crashlevel.
1999thefedfundsratetargethadreachedits
Withtheeconomiccrisispast,theFOMCwasable
pre-Russiandefaultlevel.Bythespringof2000,
toresumeitsefforttostabilizethepricelevel.By
thefundsratetargetwas6.5percent—100basis
lateJune1988thefundsratetargetwasaboveits
pointshigherthanbeforetheRussiandefault.
pre-crashlevel.
AnothermarketupsetoccurredwhenRussia
defaultedonitssovereigndebtonAugust17,1998.
LOOKING AHEAD
Inandofitself,thiseventposednospecificliquid-
The1987and1998episodes,andothers,
ityproblemsfortheU.S.economy.Thepicture
providethebestpicturewehaveofhowthecur-
begantochangewhen,onAugust26,itwasdis-
rentmarketturmoilislikelytoberesolved.Each
closedthatGeorgeSoros’QuantumFundlost$2
episodeoffinancialturmoilhasitsindividual
billioninRussianmarkets.Thefollowingdaythe
characteristicsbuttheyalsohavecommonfeatures.
spreadbetweenAAAratedcorporatebondsand
Aswethinkthroughthecurrentsituation,it
the10-yearTreasuryyieldincreased10basis
isusefultoseparatetheissuesofdistressinthe
points.Thespreadcontinuedtowidenasnews
housingmarketfromfinancialturmoilbeyond
offalloutfromtheRussiandefaultintensified.The
housing.Thewoesinthehousingmarketmay
spreadwidenedto99basispointsonSeptember2,
continueforsometime.Homepricesaredeclining.
whenLongTermCapitalManagement(LTCM)
Salesofsingle-familyhouseshavebeendeclining
announcedthatmarketdevelopmentshadwiped andtheinventoryofsingle-familyhousesforsale
outabouthalfofitscapital,whichwasminimal hasbeenrising.Nooneshouldfeelmuchconfi-
tobeginwith.Whilehedgefundscanlosecapital denceinaforecastastowhenthehousingmarket
foravarietyofreasons,itwaswell-knownthat willstabilize;theconventionalviewamong
hedgefundsthatinvestedheavilyinemerging housingexpertsandeconomicforecastersseems
markets,especiallyRussia,sufferedlargelosses. tobearoundthemiddleof2008.
3 Duringthisperiod,theFOMCsometimeschangedtheintendedfedfundsratebyamountsotherthaninmultiplesof25basispoints.There
wereactuallytwochanges,oneof18.75basispointsonJanuary27andanotherof12.5basispointschangeonFebruary11.Ihaveadded
thesetogetherandroundedoffinthetext.
6
MarketHealing
Onthefinancialside,newsubprimemort- thatthejumbospreadiscurrentlyabout60basis
gagesaremuchlessreadilyavailablethaninthe points.
past.Lendershavetakenstepstoavoidthelend- Theimplicationsofthemarketupsetforthe
ingpracticesthatgeneratedthecrisisinthesub- macroeconomyarenotclear.Residentialinvest-
primemortgagemarket,andwecanbeconfident ment,whichaccountsforabout5percentofGDP,
thatunderwritingpracticeshaveimprovedinall willcontinuetobeanegativeforeconomic
segmentsofthemortgagemarket.However,itwill growth.Consequently,thedeclineinresidential
takeseveralyearstoresolvetheproblemswith investment,perse,willhaveamodesteffecton
outstandingsubprimemortgagesandsecurities economicgrowthgoingforward.
backedbysuchmortgages.Loandelinquency Atissueisthepotentialeffectofthehousing
rates,whichhavebeentrendingupsincemid- declineonconsumerexpenditures.Thelossof
2006,arelikelytocontinuetorise.Manyhome- wealthassociatedwiththedeclineinhousing
ownerswilllosetheirhomestoforeclosure,and prices,aswellasthefactthatmortgagepayments
investorswillhavetowritedownthevalueof willabsorbalargerportionofdisposableincome
theirassetsbackedbysubprimemortgages. forsomeconsumers,mightcauseconsumption—
Whatcreatesgeneralizedfinancialturmoil thelargestcomponentofGDP—togrowatasignifi-
outofamarketproblemisthatinvestorsflee cantlyslowerrate.Whiletheeffectofachange
riskierassetsofalltypes,withlittleregardto inwealthonconsumerexpenditureshasbeen
whethertheassetsareconnectedtotheoriginal notoriouslydifficulttoidentifyempirically,
problemornot.However,aflighttoqualitytypi- somerecentevidencesuggeststhatchangesin
callydoesnotlastverylong.Investorsstartto housingwealthdoaffectconsumption.4
maketherelevantdistinctionsastheysearchfor
goodassetstradingatdistressedprices.
Thatprocessiscertainlyobservabletoday.
THE HEALING PROCESS
Broaderfinancialmarketsareshowingsignsthat
thefinancialmarketupsetisbeginningtoresolve Whatistheprocessbywhichfinancialmar-
itself.Ratesonshort-termT-billshaverisenand ketsreturntonormalfunctioning?Ihavealready
areatmorenormallevelsrelativetothefederal emphasizedthatthemostfundamentalaspectis
fundsrate.Ratesonmanytypesofriskierassets thatinvestorsquicklybegindrawingdistinctions
havedeclined.Thereappearstobeonlyamodest betweenassetswithpricesdepressedforgood
effectonratesintheconformingmortgagemarket. reasonandthosedepressedduetoageneralized
TheFreddieMacindexfortheconventional30- flighttoquality.Itdoesmakesenseforsecurities
yearmortgageratewas156basispointsabove backedbysubprimemortgagestotradeatlow
the10-yearTreasuryrateinJune;attheendof prices,becausethedefaultrateonsubprime
October,thespreadwasabout30basispoints mortgagesishighandperhapsrising.Evenhere,
higher.Althoughthespreadisabithigher,the however,notallsubprimemortgageswerecreated
absoluteleveloftheconformingmortgageratein equal.Somefirmsoriginatingthesemortgages
Octoberwasroughly25basispointsbelowits hadmuchbetterunderwritingpracticesthan
Junelevel.However,therateonprimejumbo others.Itislogicalthatinvestorswillnowdis-
mortgages—mortgageswhosesizeisabovethe tinguishbetweensecuritiesbackedbysubprime
conformingmortgagelimitof$417,000—was mortgagesoriginatedbysolidunderwritersand
about100basispointshigherthantherateon thosebySam’sCornerMortgageCompany.
conformingmortgagesfrommid-Augusttomid- Experiencecertainlysuggeststhatcentral
September.Thenormalspreadisabout25basis bankratereductionshelpspurthehealingprocess.
points.Asignofprogressinmarkethealingis Whyshouldthatbeso?
4 Forexample,seeBostic,GabrielandPainter(2005)andCatte,Girouard,PriceandAndre(2004).
7
FINANCIALMARKETS
Onethingthathappensisthatcutsinthe sionatitsnextmeetingwillbeeithertoleave
policyrate—thefederalfundstargetrateinthe therateunchangedortocutfurther.Barring
UnitedStates—servetoreducetheabsolutelevel unusualcircumstances,theFOMCwouldnot
ofratesonriskiersecuritieseventhoughspreads considerarateincreasejustaftercuttingitsfed
mayremainhigherthanbefore.IntheUnited fundsratetarget.Thisapproachtopolicyis
States,comparingtheJuly2007averagewiththe appropriatewhenmarketconditionsarefragile
averagefortheweekendingNovember2,the becausemarketparticipantsmustbeconfident
AAAcorporatebondratefellfrom5.65percent thattheycantakepositionswithouttheriskthat
to5.15percentandtheBBBcorporatebondrate theFedmightraiserates,whichwouldreduce
fellfrom6.34percentto6.09percent.Thesame assetvalues,inthenearterm.Investorscanthen
pointappliestoratesonmanyotherriskyassets. concentrateondeterminingthefundamental
SpreadsagainstTreasuriesarehigherbutthe valueofriskyassetsandcanworkondealsto
absolutelevelofyieldshasreturnedtopre- buysuchassetsfromholdersforcedtosellby
turmoillevels,orbelowinsomecases. theirownimpairedliquidityandcapitalposi-
Anotherthingthathappensasaconsequence tions.Asinvestorsaccumulateprofitsfromthese
ofcentralbankactionisanimprovementincon- trades,othersareattractedandnormalmarket
fidence.Stockmarketvolatilitymightserveasa functioningresumes.
goodmeasureofconfidence.Thestockmarket Asmarketsreturntonormal,Fedpolicycan
hasbeenquitevolatilesinceitspeakonJuly19.
alsoreturntoitsnormalfocusonthelong-run
ByAugust15,theS&P500stockindexhad
needsoftheeconomy.InJune1999,forexample,
declinedby8.3percentfromitspeak.Stocks
theFedstartedtoundotheratecutsintroduced
surgedonSeptember18followingtheFOMC’s
inthefallof1998.Itisimpossibletodetermine
actionreducingthefedfundsratetargetby50
inadvancewhatthescheduleshouldbeforthe
basispoints.Subsequently,othernewsledto
returntonormalmonetarypolicymaking.Incur-
sharpstockdeclines.
rentcircumstances,itcouldbethatthedown-
Despitemarketvolatility,Fedactionshave
draftfromthehousingindustrywillspreadto
demonstratedtomarketparticipantsthroughout
othersectors,whichmightrequirethatrecent
theeconomy—thoseinnon-financialfirmsas
ratecutsnotbereversedoreventhatadditional
wellasthoseinfinancialfirms—thattheFedwill
ratecutswouldbeinorder.Conversely,asmar-
notbeanidlebystander.TheFedneedstobe
ketsheal,thepolicysituationmayreturntoone
carefultodowhatisnecessary,butnotmore.
resemblingthatofafewmonthsagoinJune,
Excessiveratereductionswouldruntheriskof
beforesubprimeproblemsbegantohavesignifi-
increasinginflationinthefutureandinducing
cantmarketimpact.
furthermarketvolatilityasthemarketcameto
AlthoughIamunabletoforecastthefuture
fearfuturerateincreasestodealwithrisinginfla-
courseoftheFOMC’stargetforthefederalfunds
tion.MarketconfidencethattheFedhasitabout
rate,Iamconfidentthatnormalmarketfunction-
rightandispreparedtotakeappropriatefurther
ingwillreturntothefinancialmarkets.Recent
actionhelpsinthehealingprocess.
weeksshowclearprogress.Therecouldbeset-
Letmealsoofferaconjecture.Acutinthe
backsalongtheway,buttheinherentefficiency
federalfundstargetratechangesthenatureof
ofU.S.financialmarketswillultimatelydomi-
near-termrisksfacingmarketparticipantswho
natetheoutcome.
takepositionsinriskysecurities.Ihaveempha-
sizedthatthewillingnessofmarketparticipants
totakerisksisessentialtothehealingprocess
REFERENCES
thatrestoresnormaltradinginriskyassets.When
theFedcutsitstargetforthefederalfundsrate, Bostic,R.;Gabriel,S.andPainter,G.“HousingWealth,
marketparticipantsknowthattheFOMC’sdeci- FinancialWealth,andConsumption:NewEvidence
8
MarketHealing
fromMicroData.”UniversityofSouthernCalifornia
WorkingPaper,2005.
Catte,P.;GirouardN.;Price,R.andAndre,C.
“HousingMarkets,Wealth,andtheBusiness
Cycle.”OECDEconomicsDepartmentWorking
Paper394,2004.
Poole,W.“ReputationandtheNon-PrimeMortgage
Market.”PresentedtotheSt.LouisAssociationof
RealEstateProfessionals,St.Louis,MO,July20,
2007.http://www.stlouisfed.org/news/speeches/
2007/07_20_07.html.
9
Cite this document
APA
William Poole (2007, November 6). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20071107_poole
BibTeX
@misc{wtfs_speech_20071107_poole,
author = {William Poole},
title = {Speech},
year = {2007},
month = {Nov},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/speech_20071107_poole},
note = {Retrieved via When the Fed Speaks corpus}
}