FRBSF Economic Letter
2007-26-27; September 14, 2007
Recent Financial Developments and the U.S. Economic Outlook
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This Economic Letter is adapted from a speech
by Janet L. Yellen, president and chief executive officer
of the
Federal Reserve Bank of San Francisco, to the National
Association for Business Economics in San Francisco, California,
on September 10, 2007.
Good morning. It's my pleasure to welcome you to this
beautiful city. I'm delighted that NABE chose to have its
national
meeting here, and I'm especially pleased to have been
invited to speak to you today. As some of you may know,
I occasionally
use colorful language to describe the economy. Certainly,
the events in financial markets over the past couple
of months have generated their share of it. But I believe
these are times when there is particularly great value
in speaking deliberately, keeping a cool head, conducting
careful analyses, and closely monitoring emerging developments.
So those considerations will be reflected in the tenor
of my remarks today. I would like to discuss recent events
in financial markets, consider their impact on the prospects
for the U.S. economy, and offer my perspective on recent
Fed policy actions, both in its role in promoting stability
in financial markets and in its role in the conduct of
the nation's monetary policy. I want to emphasize at
the
outset that these remarks reflect my own personal views
and not necessarily those of the Federal Open Market
Committee.
Let me begin with the financial markets and review some
of the recent developments I consider to be relevant
in evaluating the prospects for the economy going forward.
Beginning in mid-July, global financial markets became
highly volatile and increasingly averse to risk. In the
U.S., perhaps the most dramatic illustration of the ensuing
flight to safety was the decline in the three-month Treasury
bill rate, which dipped by almost 2 percentage points
between
mid-July and August 20th.
Dramatically wider yield spreads on credit default swaps,
which provide insurance against default on the underlying
securities, are further evidence of increased risk aversion
in financial markets. Indeed, wider spreads are evident
for a host of underlying instruments, from mortgages
to corporate bonds, with lower-rated instruments seeing
especially
big increases in spreads. At the same time, options-based
implied volatilities on a range of assets, from equities
to foreign exchange, increased markedly, reflecting heightened
uncertainty about the future. Since mid-August, Treasury
bill rates have partially rebounded and credit default
spreads have abated somewhat, but risk aversion remains
notably high. This same turbulence has hit markets abroad,
where risk spreads and implied volatilities are up, and
there has been a significant flight to safety.
Of greater relevance to monetary policy are movements
in the borrowing costs facing households and firms, since
it is these interest rates that influence spending decisions
and aggregate demand. On the corporate side, prime borrowers
have experienced little change in their borrowing costs
because higher spreads have been offset by lower Treasury
rates. Issuers of low-grade corporate bonds with greater
credit risk, in contrast, face sharply higher borrowing
costs: spreads have widened so much that yields are up
substantially since mid-July.
In the mortgage market, increased aversion to risk has
been particularly apparent, with spreads above Treasuries
increasing for mortgages of all types. Borrowing rates
for low-risk conforming mortgages have actually decreased
somewhat. But other mortgage rates have risen, including
those available to some borrowers with high credit ratings.
In particular, rates on jumbo mortgages, both fixed-
and adjustable-rate, have risen noticeably since mid-July.
Rates on home equity loans and lines of credit are also
up, especially for those with high loan-to-value ratios.
Of course, subprime mortgages have become difficult to
get at any rate. And that reflects another sign of the
increased caution of market participants, specifically,
sharply restricted credit terms and availability. In
the mortgage market, lenders have tightened credit standards,
making nonprime and jumbo mortgages available to fewer
borrowers. For example, mortgage lenders report raising
FICO scores and lowering allowable loan-to-value ratios
in many mortgage loan programs, and many subprime programs
have been shut down altogether.
Moreover, some markets have become downright illiquid;
in other words, the markets themselves are not functioning
efficiently, or may not be functioning much at all. This
illiquidity has become an enormous problem for companies
that specialize in originating mortgages and then bundling
them to sell as securities. The markets for selling these
securities have all but dried up, except for the lowest-risk, "conforming" agency
mortgages that can be sold to Freddie Mac and Fannie Mae.
And a market where many firms, including financial institutions,
get short-term funding is illiquid as well, namely, the
market for asset-backed commercial paper—short-term business
loans that are secured by other assets, often mortgages.
With liquidity problems in the markets in which many mortgage
companies both sell assets and borrow, these firms have
faced serious challenges, and a few have gone out of business.
Depository institutions also face some illiquidity, specifically
in the funding markets for maturities in the one- to
six-month range. Compounding their liquidity problems are
concerns
that mortgages and other assets that are normally securitized
may come back onto their balance sheets and that customers
may draw on unsecured credit lines.
To assess how financial conditions relevant to aggregate
demand have changed, we must consider not only credit
markets but also the markets for equity and foreign exchange.
These
markets have hardly been immune to recent financial turbulence,
but the changes since mid-July, on balance, are less
dramatic. Broad equity indices are down, but not sharply.
And the
dollar has changed little on a trade-weighted basis,
as appreciations against the euro and pound—which may
reflect
safe-haven demands—have been offset by a big depreciation
against the yen, probably reflecting a withdrawal from
the so-called "carry trade" in which investors
borrowed at low rates in Japan and lent at higher rates
in the U.S.
As these financial events have unfolded, many explanations
have emerged. I have little doubt that scholars will
study and debate the causes for some time to come. So I
will
only offer some tentative thoughts on why all of this
happened.
The ostensible trigger seems to have been concern about
growing delinquencies on subprime mortgages. There are
legitimate and serious concerns about the extent to which
subprime delinquencies are traceable to predatory lending
practices and a deterioration in underwriting standards
over the last few years. However, some of these delinquencies
arguably resulted from environmental changes—rising
market interest rates, as the Fed removed accommodation
in the
stance of policy, and intensifying weakness in housing
markets, which slowed or reversed the long-standing trend
of significant house-price appreciation.
In this new environment, borrowers with variable-rate
mortgages have started to see their rates reset much higher
than
they may have expected, and most borrowers have seen
their home equity building up much more slowly than expected
or even shrinking. Among these are some—many in the
subprime
category—who were barely able to make the original terms
of their mortgages, in part because these loans incorporated
features like "piggyback" loans to cover down
payments, loans requiring low or no documentation, interest-only
loans, and adjustable-rate loans with the option to make
reduced payments for a time resulting in negative amortization.
For many of these borrowers, particularly those who bought
homes during 2005 and 2006, the environmental changes have
been enough to push them to delinquency or default.
While the problems with subprime mortgages have understandably
received a lot of attention, it is important to remember
that the whole subprime market itself is only a relatively
small part—10 to 15%, depending on the exact definition—of
the overall mortgage market. How, then, could problems
in this relatively small market infect so much of the
financial sector, and possibly real economic activity?
The answer
appears to lie in the characteristics of some of the
complex financial instruments that have been developed
as a means
to diversify and spread risk. These instruments include
not only mortgage-backed securities, including subprime
mortgages, but also CDOs—collateralized debt obligations
that package bonds, including mortgage-backed securities—and
CLOs—collateralized loan obligations that package business
loans—and a variety of associated derivatives, such
as credit default swaps and indices based on such swaps.
These
instruments are obviously very complex, which makes them
difficult to understand and evaluate, not only for the
average investor, but even for sophisticated investors.
In particular, it is difficult to determine the risk
embedded in these instruments and how to price them.
Investors have relied on a variety of means to assess
their exposure to them—from high-powered mathematical
models
to agencies that assign ratings to them. But models are,
at best, approximations, and, because these instruments
are relatively new, there were not necessarily enough
data available to estimate how they would do under the
stress
of a downturn in housing prices or economic activity.
As for the rating agencies, once recent developments began
to break, they quickly began announcing sharp downgrades,
which intensified awareness of the uncertainty surrounding
the risk characteristics of many of these instruments.
As delinquencies have risen in the subprime market, the
complex instruments associated with those mortgages have
come under question. Moreover, questions have arisen
concerning the underwriting standards used by financial
firms that
received fees to originate and package mortgages for
sale rather than holding them for their own account. In
consequence,
holders of these securities, many highly leveraged, have
been forced to sell into illiquid markets, realizing
prices that are substantially below their model-based estimates,
or to sell liquid assets as an alternative. Significant
losses have been realized in the process.
Once other investors saw how quickly and unpredictably
such markets could cease to function well, those who
used similar complex instruments likely grew concerned
about
how quickly and unpredictably their own exposures might
change for the worse, leading them to pull back, too.
One might say that these developments bring us back to
Latin
101 and the root of the word "credit." The root
is "credo," which means "I believe" or "I
trust"—that is, investors' belief was shaken, both
in the information they had on the degree of risk these
instruments embodied and in the price they were going for,
and they are pulling back from these markets, presumably
until they understand these instruments well enough to
restore that belief.
Even with corrections to credit underwriting standards,
it still may turn out that these innovations don't actually
spread risk as transparently or effectively as once thought,
and this would mean—to some extent—a more or less permanent
reduction of credit flowing to risky borrowers and long-lasting
shifts in patterns of financial intermediation. It also
could mean an increase in risk premiums throughout the
economy that persists even after this turbulent period
has passed. In a speech I gave a few months ago, I focused
on the phenomenon of low risk premiums in interest rates
throughout the world. In fact, there was considerable
debate about what might be causing the very low price for
taking
on risk. What we are seeing now could be the beginning
of a return to more normal risk pricing. As such, this
development would not be disturbing for the long
run.
However, as we are seeing, the transition from one regime
to the
other can be quite painful.
The Fed has three main responsibilities that pertain
to these developments: promoting financial stability to
help
financial markets function in an orderly way, supervising
and regulating banks and bank holding companies to ensure
the safety and soundness of the banking system, and conducting
monetary policy to achieve its congressionally mandated
goals of price stability and maximum sustainable output
and employment. With regard to its responsibilities for
financial market stability, the Fed recently lowered
the discount rate by 50 basis points and encouraged banks
to
borrow at the discount window, emphasizing the broad
range of collateral that is acceptable for such loans.
Such collateral
includes mortgage-backed securities and asset-backed
commercial paper that have become illiquid.
As a supervisor and regulator
of banks, the Fed has long focused on insuring that banks
hold adequate capital and
that they carefully monitor and manage risks. As a consequence,
banks are well-positioned to weather the financial turmoil.
The Fed is carefully monitoring the impact of recent
financial developments on the banking system and on core
institutions
involved in the payments system. Importantly, the Fed's
supervisory role has facilitated the collection of timely
and reliable information on developments in banking and
capital markets, and the insights gained through this
process have been critical in shaping the Fed's response
in recent
weeks.
For the conduct of monetary policy, the main question
is how recent financial developments and other economic
factors
affect the outlook for the U.S. economy and the risks
to that outlook. The reason this is the main question is
that
monetary policy's unswerving focus should be on pursuing
the Fed's mandated goals of price stability and full
employment. Monetary policy should not be used to shield
investors
from losses. Indeed, investors who misjudged fundamentals
or misassessed risks are certain to suffer losses even
if policy is successful in keeping the economy on track.
With those principles in mind, let me briefly review
recent economic developments. The U.S. economy turned in
a fairly
good performance in the first half of the year. Growth
in the first quarter was weak, but it picked up to a
robust pace in the second quarter. For the current quarter,
payroll
employment did not rise as expected, but instead actually
fell slightly in August, in part due to a drop in construction
jobs. However, recent data on manufacturing output and
on orders and shipments for core capital goods have been
upbeat, and business investment in equipment and software
promises to be a bright spot. Despite the hike in borrowing
costs for higher-risk corporate borrowers and the illiquidity
in markets for CLOs, it appears that financing for capital
spending for most firms remains readily available on
terms that have been little affected by the recent financial
turmoil. Of course, the outlook for capital spending
could
worsen if business confidence were shaken by turbulence
in global financial markets.
That said, financial market turmoil seems likely to intensify
the downturn in housing. At the macro level, we would
expect some effect on housing demand from the rate increases
related
to these markets, but the impact from rates alone would
likely be modest. More important, in my view, are the
effects stemming from disruptions to the availability of
credit
and the tightening of lending standards that are occurring.
The illiquidity in many segments of the market for mortgage-backed
securities seems likely to limit credit flows and therefore
to have at least some negative effect on real residential
construction, depending on how long the disruptions persist.
A key point is that, even when liquidity in the mortgage-backed
securities market improves, the risk spreads incorporated
in mortgage rates will likely remain higher on a long-term
basis than they have been in recent years, and this could
prolong the adjustment in the housing sector.
Indeed, forward-looking indicators of conditions in housing
markets were pointing lower even before the financial
market turmoil began. Housing permits and sales were trending
down. Inventories of unsold new homes remained at very
high levels, and they will need to be worked off before
construction can begin to rebound. Finally, most measures
of house prices at the national level fell moderately.
Notably, despite these declines, the ratio of house prices
to rents—a kind of price-dividend ratio for housing—remains
quite high by historical standards, suggesting that further
price declines may be needed to bring housing markets
into
balance. This perspective is reinforced by futures markets
for house prices, which expect further declines in a
number of metropolitan areas this year. The downturn in
house
prices would likely be intensified by a simultaneous
decline in employment, should that occur, since significant
job
loss would weaken demand for housing and raise foreclosures.
Beyond the housing sector's direct impact on GDP growth,
a significant issue is its impact on personal consumption
expenditures, which have been the main engine of growth
in recent years. The nature and extent of the linkages
between housing and consumer spending, however, are a
topic of debate among economists. Some believe that these
linkages
run mainly through total wealth, of which housing wealth
is a part. Others argue that house prices affect consumer
spending by changing the value of mortgage equity. Less
equity, for example, reduces the quantity of funds available
for credit-constrained consumers to borrow through home
equity loans or to withdraw through refinancing. The
key point is that, according to both theories, a drop in
house
prices is likely to restrain consumer spending to some
extent, and this view is backed up by empirical research
on the U.S. economy.
Indeed, in the new environment of higher rates and tighter
terms on mortgages, we may see other negative impacts
on consumer spending. The reduced availability of high
loan-to-value
ratio and piggyback loans may drive some would-be homeowners
to pull back on consumption in order to save for a sizable
down payment. In addition, credit-constrained consumers
with adjustable-rate mortgages seem likely to curtail
spending as interest rates reset at higher levels and they
find
themselves with less disposable income.
Another engine of growth that could be a little weaker
going forward due to the ongoing turmoil is foreign economic
activity. Foreign real GDP—weighted by U.S. export shares—advanced
at robust rates of 3-3/4 to 4% in 2004 and through the
first quarter of this year. This growth was widespread,
affecting nearly every continent. With the trade-weighted
dollar falling over this same period, U.S. exports have
been strong—real exports increased by an average of
nearly 8% during 2004 through 2006. Partly for this reason,
U.S.
net exports, which consistently held growth down from
2000 to 2005, actually gave it a lift during 2006. Before
the
recent global financial turmoil, I had assumed a modest
deceleration in world economic activity, which meant
that net exports were likely to "turn neutral"—neither
retarding nor stimulating growth in the year or so ahead.
At this early stage of the financial turmoil, it's very
difficult to gauge the likelihood of this "neutral" scenario,
but it does seem safe to say that these developments add
some downside risks to it.
To sum up the story on the outlook for aggregate demand,
I see significant downward pressure based on recent data
indicating further weakening in the housing sector and
the tightening of financial markets. As I have indicated,
a big issue is whether developments in the relatively
small housing sector will spread to the large consumption
sector,
perhaps through declines in house prices. Should the
decline in house prices occur in the context of rising
unemployment,
the risks could be significant.
While I do think that the present financial situation
has added appreciably to the downside risks to economic
activity,
we should remember that conditions can change quickly
for better or for worse—especially in financial markets—so
it's hard right now to speak with a great deal of confidence
about future economic developments. It's also important
to maintain a sense of perspective: past experience does
show that financial turbulence can be resolved more quickly
than seems likely when we're in the middle of it. Moreover,
the effects of these disruptions can turn out to be surprisingly
small. A good example is the aftermath of the Russian
debt
default in 1998. Many forecasters predicted a sharp economic
slowdown as a result; but instead, growth turned out
to be robust.
Turning to inflation, signs of improvement in underlying
inflationary pressures are evident in recent data. Over
the past 12 months, the price index for personal consumption
expenditures excluding food and energy, or the core PCE
price index, has increased by 1.9%. Just several months
ago, the 12-month change was quite a bit higher, at nearly
2-1/2%. I anticipate that the core PCE price index will
edge down slightly further over the next few years. This
view is predicated on continued well-anchored inflation
expectations. It also assumes the emergence of some slack
in the labor market, as well as the ebbing of the upward
effects of several special factors—including energy
and commodity prices and owners' equivalent rent.
With that view of recent financial developments and the
outlook for the U.S. economy, I'd like to turn to Fed
policies. It's unusual for me to use the plural—policies—because
I'm normally referring only to monetary policy in which
the FOMC pursues its dual mandate for the overall economy
of full employment and price stability.
However, this time around the Fed took a number of steps
to help restore liquidity in the financial markets, some
of which I have already mentioned. One step involved
a sizable injection of reserves to prevent the federal
funds
rate from rising above its 5-1/4% target in the face
of huge demands for short-term, liquid funds. In addition,
on August 17 the Fed announced that the discount rate
had
been cut 50 basis points to narrow the spread with the
target federal funds rate. The statement also indicated
a change to the usual procedure, namely, to allow loans
of up to 30 days, renewable by the borrower. Furthermore,
the Fed made clear that asset-backed commercial paper,
which had become highly illiquid, is acceptable as collateral
for discount window borrowing. These efforts to encourage
the use of the discount window were designed to promote
the restoration of orderly conditions in financial markets
by providing depositories with greater assurance about
the cost and availability of funding. While helpful,
these actions have not, however, served as a panacea.
On the same day, the Fed also issued a new statement
on monetary policy, which said, and I quote: "although
recent data suggest that the economy has continued to expand
at a moderate pace, the Federal Open Market Committee judges
that the downside risks to growth have increased appreciably." This
assessment apparently is similar to that of market participants.
Investors' perceptions of increased downside risks have
resulted in a notable decline in the rates on federal funds
futures contracts and their counterparts abroad. The statement
emphasized that the Committee is prepared to act as needed
to mitigate the adverse effects on the economy arising
from the disruptions in financial markets.
In determining the appropriate course for monetary policy,
we must recognize that most of the data available now
reflect conditions before the disruptions began and, therefore,
tell us less about the appropriate stance of policy than
they normally would. In addition to data lags, appropriate
policy decisions must also, I believe, entail consideration
of the role of policy lags—that is, the lag between
a
policy action and its impact on the economy. Addressing
these policy complications requires not only careful
and vigilant monitoring of financial market developments,
but
also the formation of judgments about how these developments
will affect employment, output, and inflation. In other
words, I believe it is critical to take a forward-looking
approach—gauging the effects of recent developments
on the outlook, and, importantly, the risks to that outlook. Janet L. Yellen
President and Chief Executive Officer
Endnotes
I would like to thank San Francisco
Fed staff members John Judd and Judith Goff for excellent
assistance in the
preparation of these remarks.
Janet Yellen, “The
State of the Global Economy.” Presentation
to a conference celebrating Professor Rachel McCulloch,
Brandeis University, Waltham,
Massachusetts, June 15, 2007.
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
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