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?

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.

Overview of the Financial Crisis

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.

• 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 Fed’s Initial Response to the Financial Crisis:

• 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).

The Term Auction Facility (TAF)

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.

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. 

Housing Permits and Housing Starts

The risk premium is increasing 

Credit Market Risks: Mortgage Markets

The risk premium is also increasing in bond markets

Credit Market Risks: Bond Markets

The unemployment rate is rising

Unemployment

Employment growth has been trending downward

Employment Growth

The index (red) is falling and is now below 50 indicating a slowing economy.

Index of Manufacturing Activity

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.

Consumption(percentage change over previous month)

Expect slow growth, and hope the Fed can prevent bigger problems

San Francisco Fed’s GDP Growth Forecast

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.

Inflation Shows Signs of Moving 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 meansof lending money, so moving the amount (ii) oughtto be sufficient to change the amount of reserveschanneled through bank borrowing

Changes In Financial Market Regulation:

Lots of possibilities here – too many to coverin any depth – but some general principles are:

• To create more transparency concerning the risksembedded in financial assets

• Make sure that the individuals who are assuming risksface the full consequences of their decisions.

• To prevent fraud and misrepresentations

Monetary Policy Alone May Not Be Enough

• Responsiveness of consumption and investmentto 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 ashousing 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 lossescannot be recovered – and there is no way to avoid someadjustment.

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. Incomecut-off is $75,000 for an individual, $150,000 for acouple.

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.

Thank You

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]