Transcript Slide 1

The Financial Crisis, the Current Economy, and
the Economic Outlook
• How did the economy get into its present condition?
How have policymakers responded so far?
Has it worked?
• Are we headed for a recession?
• What can monetary and fiscal authorities do to prevent
or reduce the severity of a recession should one occur?
Overview of the Financial Crisis
During a time of easy money from
• low interest rates from Fed policy after 2001 slowdown
• high international saving (Asia, oil-producing nations)
and a housing boom fueled by
•
•
•
•
risk misperception from lack of transparency
Regulatory, oversight, and rating agency failures
financial innovation
the belief that prices would continue to rise
Many people bought houses at prices much higher than justified by
underlying fundamentals. Now that prices are falling, many of the
houses are valued at less than their mortgages and losses are
inevitable. As the losses are revealed, fear mounts, and credit
markets dry up.
How Have Policymakers Responded So Far?
First, Getting Policymakers Attention:
• Housing had been in decline since 2006
• There were signs of trouble in 2007, e.g.
problems in bond markets and stock market
turmoil, but this was mostly thought to be
localized and not enough to severely impact the
larger economy
• Then, on August 9 of last year, there was a
“significant liquidity event” and the ff-rate shot
upward as the demand for bank reserves
increased and liquidity began drying up. This
motivated a policy response.
The Fed’s Initial Response to the Financial Crisis:
• Open market operations: use standard policy tool to pump up
reserves and make sure traditional banks had the liquidity
they needed.
• Problem: It quickly became clear that a “non-bank” bank run
was in progress drying up the commercial paper market and
putting strains on the availability of credit.
• So what to do? Next, along with rate cuts beginning on 9/18,
they tried easing the terms for the discount window. In
particular, they began accepting “high-quality” asset backed
securities as collateral on discount window loans/repos which
allowed an indirect route to troubled institutions in need of
liquidity. They actively encouraged big banks to use the
window, and they cut the discount rate by .50 relative to ff-rate
to encourage usage
The Term Auction Facility (TAF)
• But the stigma of using the discount window discouraged
banks from using this source of needed liquidity.
• So the Fed next established the term auction facility TAF:
Under the term auction facility (TAF), the Federal Reserve
auctions term funds to depository institutions. All advances
must be fully collateralized. Each TAF auction will be for a
fixed amount, with the rate determined by the auction
process (subject to a minimum bid rate).
Two key things:
• It is anonymous removing the stigma of borrowing.
• The rate is currently below the federal funds-rate. It
has a floor – the 30 day ahead expected federal funds
rate – but this is below the federal funds rate right now
since markets are expecting further rate cuts. [More
recently the rates are closer together]
As shown on the next graph, this has caused non-borrowed
reserves to plummet and borrowed reserves to increase:
Though this set off a mild panic among a few who looked only at
the non-borrowed reserves portion of the balance sheet, it is just
what you would expect.
Has the TAF worked? At first, there we indications that bank loans
were holding up.
But, more recently there are new reasons to worry.
First, there have been some worrying signs that
commercial property values are beginning to decline (e.g.,
the MIT index)
Second, the increase in investment may be a statistical
illusion. One example is a “liquidity put”. Suppose a bank
created an SIV (special investment vehicle) with an
agreement to provide a credit line to pay off investors if
they want out. If the bank is forced to extend the credit, it
looks as if bank credit has expanded. Firms may also be
turning to banks because newer, more innovative
financing has dried up.
Third, there’s a squeeze on credit cards, there have been
problems with student loans, municipal bonds, commercial
real estate, and the value of leveraged loans is falling (see
graph)
But the problems in the asset-backed commercial paper market
continue. So it’s not over (and there are bond insurance worries,
more on this later)
Are We Headed for (or Already in) a Recession?
• Borrow some graphs from the San Francisco Fed and
take a look at present conditions.
Housing Permits and Housing Starts
Over the past 12 months housing starts and housing permits have fallen by close to
25%. Home sales are down 34% over the past year. Sales of existing homes are
down 20% over the past year.
Falling sales are showing up in a rising stock of unsold homes and declining home
prices.
Credit Market Risks: Mortgage Markets
The risk premium is increasing
Credit Market Risks: Bond Markets
The risk premium is also increasing in bond markets
Unemployment
The unemployment rate is rising
Employment Growth
Employment growth has been trending downward
Index of Manufacturing Activity
The index (red) is falling and is now below 50 indicating a slowing economy.
Consumption
(percentage change over previous month)
Consumption has remained strong (so far), and is well above values
typically seen in recessions. Retail sales were strong too, but falling
housing values may impact consumption down the road.
San Francisco Fed’s GDP Growth Forecast
Expect slow growth, and hope the Fed can prevent bigger problems
Inflation Shows Signs of Moving Upward
Pushed by rising energy prices, the PCE price index is rising, as is core
PCE.
On the positive side, longer-term inflation expectations still appear to be
stable, though there are some indications they are beginning to edge
upward.
What are the Potential Monetary, Fiscal, and
Regulatory Responses?
Monetary Policy:
• Changes in the federal funds rate
• Discount window and related operations
• Changes in financial market regulation
Fiscal Policy:
• Changes in taxes and transfers
• Changes in government spending, including
investment in infrastructure
Other:
• Insurer of last resort for bond markets
• Insure jumbo loans (Fannie/Freddie)
Potential Monetary Policy Responses
Changes In The Federal Funds Rate:
Expected Federal Funds Rate Target
Changes In the Discount Rate:
• As noted earlier, this was lowered from 1% above
the ff-rate to .5%, and it has tracked the
ff-rate downward, but due to the stigma of using the
window further lowering is unlikely to help unless they
are willing to set it below the ff-rate (as TAF did recently).
Changes In the TAF:
• They could (i) lower the floor, (ii) increase the
amount auctioned, or (iii) relax the terms.
• Currently this seems to be working as a means
of lending money, so moving the amount (ii) ought
to be sufficient to change the amount of reserves
channeled through bank borrowing
Changes In Financial Market Regulation:
Lots of possibilities here – too many to cover
in any depth – but some general principles are:
• To create more transparency concerning the risks
embedded in financial assets
• Make sure that the individuals who are assuming risks
face the full consequences of their decisions.
• To prevent fraud and misrepresentations
Monetary Policy Alone May Not Be Enough
• Responsiveness of consumption and investment
to interest rate changes in a recession may be low.
• May have trouble impacting long-term interest rates
in a global financial market.
• Relies upon changing the value of assets such as
housing and the hope people respond to lower interest
rates. They may not.
• Long lags between the policy change and the response
of the economy
• In any case, the Fed cannot fix everything – some losses
cannot be recovered – and there is no way to avoid some
adjustment.
Potential Fiscal Policy Responses
Changes in Taxes and Transfers
• Important to realize these create incentives,
so may not work if directed at wrong target
• Current proposal
One-time rebates of up to $600 for individuals,
$1,200 for couples and $300 for each child. Income
cut-off is $75,000 for an individual, $150,000 for a
couple.
Low-income individuals, including retirees on Social
Security and disabled veterans who pay no income
taxes, would receive checks of $300.
Business tax cuts, including accelerated deprecation
Changes in Government Spending
• This impacts aggregate demand with more certainty than
tax changes, particularly in recessions.
• Can enhance automatic stabilizers and relief programs
(e.g. UI and food stamps)
• Can replace revenue lost to state and local governments
(could be a big problem due to fall in property taxes)
• And, given the slow response of employment in last two
recessions, infrastructure spending is also attractive (and
also benefits long-run growth)
Potential Problems with Fiscal Policy
• To be effective, fiscal policy should be targeted, temporary,
and timely.
• If people expect that taxes will be higher in the future, loses
some (but not all) impact.
• With globalization, some of the benefits “leak out”.
• Tax rebates may be saved, not spent.
• It’s too slow to implement, political process dilutes
effectiveness.
• May increase the deficit if policymakers are unwilling to
pay for the stimulus package when times are better
What to Do?
• I would do both types of policy (and, of course, implement
regulatory reform over the longer run).
• Money policy is preferred, but if you wait until you know if it works
or not, and it may not, it’s too late to get fiscal policy in place as a
backup. So do both. Having both types of policy in place helps to
reduce the chance of a more severe downward spiral.
• The Fed should also continue to attempt to find the liquidity
chokepoints in credit markets and if possible find ways, within the
confines of the Fed’s powers, to overcome them.
• Shore up bond insurance markets, ratings agencies.
• Hope that one or some combination of the policies works.
On a more positive note, not everyone thinks we are
headed for a big downturn…
Federal Reserve Bank of St. Louis President William Poole
said that the U.S. will probably avert a recession and that
the Fed's interest-rate policy is appropriate for the slowing
economy.
''The best bet is that we will not have a recession,'' he
said... ''My take on the current policy situation is that policy
is at a good place for both the long-run concern and for
cushioning the impact of financial disturbances.'' ...
[Bloomberg 2/12]
Thank You