FedViews

FedViews – April 10, 2008

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Glenn Rudebusch, senior vice president and associate director of research at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook:

• Three key recent developments have important implications for the national economic outlook: the continuing surge in prices of energy, food, and other commodities, the deepening slump in the housing market, and the severe crisis in credit markets.

• In the wake of strong worldwide demand for energy, as well as concerns about supply in a variety of countries, oil prices have jumped to all-time highs. These higher oil prices sap household income and boost overall inflation. Over time, they should also damp demand; however, consumers in other countries have not suffered the same price increases that we have. Because the price of oil is set in dollars and the dollar has depreciated against many other currencies, energy prices have risen much less in those countries. For example, in much of Europe, the increase in oil prices over the past few years is about one-half as large as that for the U.S.

• Besides crude oil, prices for a wide variety of other commodities have risen, suggesting the importance of increased global demand as a driving factor, instead of commodity-specific supply factors.

• Housing starts for new residential construction continue to plunge. This latest housing boom and bust cycle has been as severe as any in the postwar period (which is remarkable because earlier housing cycles were exacerbated by Regulation Q restrictions and a more volatile macroeconomic environment). At the same time, relative to current sales rates, there is a glut of housing on the market. Indeed, it would take over nine months at the current rate of sales just to clear out the existing stock of homes on the market. This overhang of inventory puts continued downward pressure on prices.

• The credit crisis encompasses many financial markets on Wall Street and abroad. However, its origin is intertwined with the boom and bust of the housing sector. The subprime mortgage market is a key element of that boom and bust.

• The one-sentence summary of the subprime mess, to quote Treasury Secretary Henry Paulson, is that “There were mistakes made by all.” Lending institutions and mortgage brokers made loans that were likely unsustainable, borrowers took on obligations they likely couldn’t repay, and appraisers facilitated these transactions with optimistic valuations. The poor underwriting was encouraged by a system in which loans were not held by the mortgage originators, but securitized and sold off to investors. Such securitization is generally considered useful, in part, because it can facilitate portfolio diversification; however, in this case, the “structured credit” was so novel and complex that it was difficult to price. In particular, many investors were “reaching for yield” and downplayed the risks they were taking on. Furthermore, our fragmented financial regulatory system was not well suited to guard against such problems.  

• Problems were reinforced by a feedback cycle between home prices and mortgage financing. As long as home prices were rising, borrowers were able to build equity, delinquencies were low, and financing was readily available. Easy credit encourages more borrowing, more housing demand, and higher house prices. So during the boom, the connection between easy credit and higher prices helped to inflate a price bubble and promoted lax lending standards.

• But on the way down, this same relationship turned into a vicious cycle: As home prices decreased, home equity fell, delinquencies rose, and mortgage financing pulled back, crimping housing demand and pushing home prices down further. This feedback cycle poses a macroeconomic risk—one that the Fed is trying to short-circuit with lower rates—but it also poses a risk to the owners of the mortgage-backed securities.

• The underlying riskiness of the mortgage-backed securities was exposed when the housing sector started to cool off, and delinquencies and foreclosures started to rise. Subprime mortgages—and especially subprime adjustable rate mortgages—have gone into delinquency at unprecedented rates. These rising delinquency rates triggered the current credit crisis, as investors realized that they had greatly underestimated their risk exposure to the subprime sector. The investors’ and rating agencies’ risk-assessment models were not well suited to value securities based on “originate-to-distribute” mortgages. And since these securities were widely distributed both in the U.S. and abroad, investors raised questions about the balance sheets of many financial firms.

• One indicator of investors’ loss of confidence and greater  uncertainty is the spread between the short-term interest rate at which banks lend to each other—the LIBOR—and the expected federal funds rate. Typically, this spread is less than 10 basis points, but last August, the uncertainty in valuing structured credit translated into uncertainty about the liquidity and valuation of bank balance sheets. Therefore, conditions in the interbank lending market deteriorated markedly and persistently. The widening spreads signaled heightened concerns about counterparty risk and liquidity, which led to disruptions and dislocations in credit markets. 

• The valuation uncertainty is also evident in the equity prices for financial firms, which have performed poorly during the past year—even relative to the broader market.

• Furthermore, it wasn’t just subprime-mortgage-backed securities that lost investors’ confidence. For example, the spreads for asset-backed commercial paper have widened, making credit more expensive for a range of businesses. A broad range of other structured credit products also came under scrutiny—such as those backed by prime and jumbo mortgages, municipal debt, and student loans.

• The credit crisis has also affected consumer finance and especially fixed-rate mortgage rates. Typically, conventional mortgage rates run about 150 basis points above the 10-year Treasury yield, and jumbo rates run about 25 basis points higher than that. Now conventional rates are about 250 basis points above the Treasury yield, and jumbo rates are a further 150 basis points higher because of difficulties in the market for mortgage-backed securities. These spreads have widened despite the fact that the Fed has eased monetary policy.

• Indeed, as the credit crisis developed and the economic outlook soured, the Fed cut the funds rate by 300 basis points and the discount rate by 375 basis points, so the spread between the two has narrowed to 25 basis points. Treasury yields have also fallen—the 2-year rate is down over 300 basis points from its peak—which helps, for example, many borrowers with adjustable-rate mortgages. However, for some, rising risk spreads have offset, or more than offset, the effects of lower Treasury rates.

• Of course, in other respects the Fed’s recent actions have been unprecedented, namely, its initiatives to promote liquidity. These actions were taken to support the functioning of financial markets and prevent a chaotic freezing up of the overall financial system. In the past, the Fed could provide liquidity via open market operations to primary dealers or discount window lending to depository institutions. With these new actions, the Fed has significantly expanded its role as a liquidity backstop not just to banks but to other financial firms that may be seen as too large or too interconnected to fail. The regulatory framework to go along with this expansion is still to be worked out.

• These three key developments have important implications for the economic outlook. The surge in commodity prices curtails real income and spending and may pass through to core inflation. The housing slump depresses new construction and reduces household wealth and spending. The credit market turmoil raises the cost of borrowing, reduces wealth and spending, and erodes confidence.

• We have already seen some weakening in household spending. Consumer sentiment has turned very gloomy, and consumer credit appears to be constricted.  In the first three months of this year, there has been a notable falloff in sales of automobiles, SUVs, and pickup trucks.

• Household spending has likely been curtailed by recent slower growth in income, as the number of jobs has actually been shrinking. Last Friday’s labor report showed that nonfarm payroll employment fell by 80,000 jobs in March, with declines in the construction and manufacturing sectors. All in all, that report was the worst showing in five years, and recent data looked remarkably similar to the first few months of the recession in 2001.

• Other labor market indicators also suggest that conditions have deteriorated at a pretty rapid pace over the past few months. Notably, the unemployment rate jumped to 5.1 percent in March from 4.8 percent the month before.

• We anticipate essentially no growth during the first half of this year, and there is a fairly high probability that the current quarter could be negative. Whether this qualifies technically as a recession is harder to judge. One often hears about the rule of thumb that two negative quarters define a recession, but the last recession had three negative quarters but not two in a row. Indeed, in the past, just one quarter of negative GDP growth has often been associated with a recession. Looking further ahead, we foresee a moderate recovery starting in the second half of this year as the housing sector stabilizes, the financial crisis eases, and fiscal and monetary policy actions begin to stimulate activity.

• The other key question is whether core inflation will remain contained. Higher commodity prices pose some upside risk, but the slowdown in the economy should restrain future inflationary pressures. Therefore, we anticipate that core inflation will remain around 2 percent this year and next.

The views expressed are those of the author, with input from the forecasting staff of the Federal Reserve Bank of San Francisco. They are not intended to represent the views of others within the Bank or within the Federal Reserve System. FedViews generally appears around the middle of every month. The next FedViews is scheduled to be released on or before May 12, 2008.