Wisconsin Bankers Association
Thank you, Jeff Mayers [president of WisPolitics.com, WisBusiness.com] for that introduction. And thanks to the Wisconsin Bankers Association for inviting me to speak. I'm delighted to be here to share my thoughts on the economy during this challenging period. As always, these are my own views and not necessarily those of my colleagues in the Federal Reserve System.
Today we find ourselves in the midst of a serious recession—one that may end up being more like the large downturns in the 1970s and 1980s than the more moderate contractions of 1990 and 2001. I want to use my time today to discuss briefly how we got to this point, the outlook going forward, and the policy challenges that will be confronting the Fed as we move through these troubling times.
How did we get here?
Last Friday the Bureau of Labor Statistics reported that the cumulative job loss in December alone was over 550,000 jobs. Since the beginning of the recession in December 2007, 2.6 million jobs have been lost, 1.9 million in the last four months. In December 2007 the unemployment rate was just 4.9 percent; it ended 2008 at 7.2 percent. The latest data on household and business spending are no more encouraging. Overall economic activity has declined substantially over the past six months despite aggressive moves by the Fed that lowered the fed funds rate to near zero and tripled the size of our balance sheet, as well as major actions by the Treasury and Federal Deposit Insurance Corporation (FDIC) aimed at addressing difficulties in credit markets.
How did we get here?
In 2007 housing prices peaked, mortgage defaults rose, and strains began to appear in the market for securitized mortgages. The problems in mortgages spilled over to other segments of our financial markets. Market participants reassessed risk, and the prices of many assets declined. This cascading process of re-pricing had a detrimental impact on the liquidity and capital positions of a wide range of financial institutions in the United States and around the world.
By the spring and summer of 2008, the tightening of credit conditions had begun to weigh on business spending, and by the fall, household spending was affected as well. Spending was also reduced by the protracted weakness in housing markets, declines in financial wealth, and substantial increases in prices for energy and other commodities. These factors contributed to negative gross domestic product (GDP) growth in the third quarter of 2008.
As we moved through last year, many financial firms began reporting severe losses. Some institutions—notably Bear Stearns, Wachovia, Washington Mutual, and Merrill Lynch—appeared unable to survive on their own and were purchased by large banks. In the case of Bear Stearns, this occurred with assistance from the Fed. In the case of Lehman Brothers, the losses were especially large, and no buyer came forward at suitable terms. As a result, Lehman had to declare bankruptcy. At about the same time, American International Group (AIG), an important provider of large credit default insurance during this period, was unable to fund its liabilities. The Federal Reserve and the Treasury were able to arrange a package of loans and guarantees for AIG in order to support the functioning of markets that had important exposures to these credit default swaps and related instruments.
And as we moved through the summer, ongoing developments in the financial markets dealt a series of blows to market confidence. The problems with such major institutions intensified financial market participants' concerns about the ability of their counterparties to repay debt. Money market mutual funds, important suppliers of funds to short-term credit markets, were exposed to potentially significant losses, and many investors began making withdrawals. To meet the redemptions, many money market funds liquidated assets into an already depressed market. As perceived price risk and redemption risk increased dramatically, there was a marked reduction in the maturity of commercial paper and other debt being rolled through the markets.
As a consequence of these pressures, even some highly rated firms have found it more difficult and expensive to obtain short-term financing. Some of these firms have been able to tap bank backup lines of credit. But this substitution just pushes the money market difficulties back into the banking system, squeezing out the ability of banks to make other loans.
Actions by the Federal Reserve
In response to these extraordinary events, the Fed has implemented a number of policies aimed at mitigating the problems in the financial system and their potential fallout on the rest of the economy.
First, the Fed turned to its traditional monetary policy instruments; that is, it reduced the federal funds rate and the discount rate. The first funds rate cut occurred in September 2007. The initial moves were measured, but they eventually gave way to more aggressive rate cuts. At the last Federal Open Market Committee (FOMC) meeting, the funds rate was essentially cut to zero—525 basis points lower than when we began.
Although the corresponding injections of liquidity helped credit conditions somewhat, it became clear early on that further and alternative extensions of central bank liquidity would be necessary to facilitate market functioning.
The Fed made a number of substantial changes to the discount window operations since August 2007 to encourage its use as a source of liquidity: We reduced the spread of the discount rate over the federal funds rate from 100 to 25 basis points; we increased the maximum maturity of the loans from overnight to 90 days; and we introduced a new facility that provides loans through auctions to overcome any stigma that was associated with discount window loans. As a result, we have seen a large increase in lending to depository institutions.
Early in 2008, new market dysfunctions emerged, such as the collapse of the auction rate security market. And then there was the sudden demise of Bear Stearns last March. These episodes clearly indicated that in this strained environment, financial market participants other than depository institutions might face liquidity shortfalls that could have serious, far-ranging repercussions for the economy. This led the Fed to create a number of facilities to directly provide liquidity to nondepository institutions; the Federal Reserve Act grants us such emergency powers when the economy is faced with "unusual and exigent circumstances."
At first, these measures were aimed at lending to broker-dealers who engage in securities transactions with the Fed and who have a large-scale presence in short-term funding markets. Subsequently, we have introduced lending facilities to help work through the disruptions in the money market mutual fund and commercial paper markets. These programs provide a liquidity backstop for commercial paper and facilitate the sale in secondary markets of a number of instruments held by money market funds. The Fed began to purchase debt obligations and mortgage-backed securities issued by Fannie Mae, Freddie Mac, and other government-sponsored enterprises. This initiative will help support the flow of credit and lower credit costs in mortgage markets. Indeed, we have already seen a notable reduction in the spreads of conforming mortgages to Treasury bonds since the program has been announced.
Of course, the Federal Reserve has not been alone in dealing with the crisis. The FDIC increased deposit insurance limits and put in place special facilities to insure other liabilities of depository institutions. Congress enacted the Emergency Economic Stabilization Act, which authorized the Treasury Department's Troubled Assets Relief Program, or TARP. This program has so far provided more than $335 billion in capital injections to the financial system to support the lending capacity of banks.1 And, as you are aware, these capital injections are made through the purchase of preferred stock and also include other features that support the prudent stewardship of taxpayer resources.
In another joint program, the Federal Reserve and the Treasury established the Term Asset-Backed Securities Loan Facility, or TALF. This facility is designed to support the demand for asset-backed securities by reducing the likelihood that future liquidity needs could force holders to sell them into a depressed market. Holder of securities that are bundles of student, consumer, and small businesses loans can borrow from the TALF, using the securities themselves as collateral. TARP funds provide credit protection to the facility.
The traditional easing of monetary policy and the nontraditional actions by the Federal Reserve, Treasury, and other government agencies all are working to support the functioning of credit markets and reduce financial strains. These actions and the work being done in the private sector to reassess risks and shore up balance sheets will help move us back toward something resembling financial stability. But this will not be an easy process, and it could take some time before financial markets function in a manner that noticeably facilitates the activities of businesses and households. Until they do, we will continue to experience some drag on activity in the nonfinancial sectors of the economy. And as we know too well, spending, production, and job creation all currently are contracting at a disturbing pace.
Let's now take a look at these recent developments in overall economic activity as well as the outlook for the next few years.
The National Bureau of Economic Research declared the U.S. economy peaked in December 2007 and subsequently entered into a recession. Overall GDP growth has been choppy, but in the third quarter of 2008, GDP fell at an annual rate of 0.5 percent. Most indicators point to a large contraction in economic activity in the fourth quarter, with many private sector forecasters looking for a drop of 5 percent or more.
As I stated at the outset, labor markets have deteriorated significantly over the last few months. Weak labor markets have held back growth in real incomes. Along with the financial strains, these factors have led to weak business investment, industrial production, and consumer spending. Indeed, the declines in consumer spending over the past few months have been very large—on par with the drops experienced during the 1990 and 1982 recessions.
The housing market has continued to deteriorate, with construction, new home sales, and home prices all declining further in recent months. In the business sector, investment in equipment and software continued to contract. Weakening foreign activity and the higher dollar are reducing exports.
Over the last several months we've seen a further pullback in risk-taking in financial markets, spurred in part by the more pessimistic outlook for economic activity. This led to lower equity prices, higher risk spreads, and tighter constraints in credit markets, all of which fed back into a further decline in real activity.
Going forward, rising unemployment, low levels of consumer sentiment, losses in stock market wealth, declining home values, and restrictive credit conditions are likely to continue to weigh on household spending. Business expenditures are also likely to be held back by a weaker sales outlook and tighter credit conditions. Consequently, real GDP is likely to fall sharply in the first half of 2009. We expect GDP growth to slowly recover over the remainder of the year, reflecting the support from both traditional and nontraditional monetary policies, fiscal policy actions (many of which are yet to be enacted), and progress by the financial markets in working through their difficulties. I expect real GDP to decline for 2009 as a whole and to rise at a pace in the neighborhood of potential growth during 2010. However, this growth will not be strong enough to close the resource gaps emerging over this period. Indeed, the unemployment rate—the main resource gap measure in the labor market—is likely to rise into 2010.
On the inflation front, headline consumer prices declined in recent months, since energy prices fell sharply and increases in consumer food prices moderated. Falling prices for energy and other commodities, declines in import prices, and the increase in resource utilization slack due to diminished economic activity have resulted in an appreciable reduction in inflationary pressures. These, along with some moderate reductions in inflation expectations, have caused me to reduce my forecasts for both core and overall personal consumption expenditures (PCE) inflation. I expect core inflation to slow considerably in 2009 and then to edge down further in 2010. My modal forecast is for inflation to level out within the range we generally see as being consistent with price stability, somewhere between 1-1/2 to 2 percent. There is notable risk that inflation will decline below this range in the medium term. We could see more declines in the headline inflation numbers—which includes both food and energy components—in the near term because of declining energy prices. However, I do not currently see much risk of an outright deflationary episode, that is, a period of sustained declines in the prices for a wide range of goods and services.
Some Perspectives on Policy
Let me now turn to the policy picture. The traditional monetary policy action used to combat sluggish economic activity is to lower the fed funds rate. This in turn reduces other borrowing rates and thus stimulates aggregate demand. At its last meeting, the FOMC moved the funds rate down very close to zero. In doing so, we judged that the benefits of these low rates in stimulating demand outweighed the possible adverse effects the low rates might have on the operations of some banks and other financial firms. With the fed funds rate now near zero, we cannot lower it any further. So, going forward, the Committee will have to focus on other ways to impart additional monetary stimulus to the economy.
One way that monetary policy influences financial and economic activity is through the clarity of our intentions and communications. The manner in which the FOMC communicates policy clearly influences its effectiveness. And expectations of likely future outcomes, including those for monetary policy, obviously matter for decisions made by households and businesses today. In this vein, at a time when near-term inflation is likely to be lower than usual, having an explicit numerical objective for inflation could help keep inflation expectations from falling very far. Such an anchor on inflation expectations would help preserve low real inflation-adjusted interest rates.
As I discussed earlier, the Federal Reserve has already adopted a number of nonstandard policies that are providing liquidity support to a range of institutions and markets. If credit market functioning does not improve, and if the outlook for economic activity does not begin to show signs of improvement, it may be necessary to use these nontraditional tools further.
For example, it could be useful to purchase significant quantities of longer-term securities such as agency debt, agency mortgage-backed securities, and Treasury securities to reduce borrowing costs for a range of longer-term instruments. Similarly, possible changes in the size and scope of credit facilities would lower the cost of borrowing in particular targeted markets.
Of course, as economic activity recovers and financial conditions normalize, the use of nontraditional policy tools will have to be scaled back, the size of the balance sheet and level of excess reserves will have to be reduced, and the FOMC will return to its traditional focus on the federal funds rate. Some of this scaling back will occur naturally as market conditions improve, on account of how these programs have been designed. Still, financial market participants need to be prepared for the eventual dismantling of the facilities that have been put in place during the financial turmoil.
To conclude, the U.S. economy continues to face many challenges. The Fed has been proactive in addressing market liquidity stress during the financial crisis—first by using our traditional monetary policy tools and later through our improvised lending facilities. Moving forward, it is important that we be vigilant in monitoring the risks to growth, as well as any risks to the prospects for obtaining price stability. It is also important for us to continue to collaborate with policymakers across the globe in the pursuit of financial stability worldwide. We likely are in for a protracted period of poor economic performance. But the policy actions taken by the Fed and other governmental agencies over the course of the financial crisis, and the effort of the private sector to work through its difficulties, will eventually help support a recovery in economic growth.
Yet, undoubtedly, the greatest challenge we face is the enormous uncertainty of our situation. One great feature of being an economist in Chicago is that we benefit from the wisdom of many distinguished scholars at our local universities. An example of such wisdom is an observation made long ago by Robert Lucas, a Nobel Laureate from the University of Chicago: "As an advice-giving profession, we economists are in way over our heads." At any time, this is a sobering and humbling thought to remember. Nevertheless, in the current environment, the pursuit of a range of robust policies in the face of large uncertainties is likely to be most efficacious. A good decision-maker can't place all of his or her policy bets on a single hypothesis when the evidence is still ambiguous.
The need to act in the presence of ambiguity and such unusual events certainly adds to our policy and communications challenges.
We need to work very hard to explain the risks that we are facing and the rationale for why we think our policy actions best address those risks. Much digital ink has been spilled in these attempts so far. More is on the way. If ink were fiscal stimulus, we might see a more rapid economic recovery in 2009.
1 TARP has provided $250 billion to financial institutions, $40 billion to AIG, $25 billion to Citigroup, and $20 billion in other lending to institutions (U.S. Treasury Department, 2009, report, January 12).
Note: Opinions expressed in this article are those of Charles L. Evans and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.