Ben S Bernanke: Financial markets, the economic outlook, and monetary
policy
Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Women in Housing and Finance and Exchequer Club Joint
Luncheon, Washington DC, 10 January 2008.
* * *
Since late last summer, the financial markets in the United States and in a number of other
industrialized countries have been under considerable strain. The turmoil has affected the
prospects for the broader economy, principally through its effects on the availability and
terms of credit to households and businesses. Financial market conditions, in turn, have
been sensitive to the evolving economic outlook, as investors have tried to assess the
implications of incoming economic information for future earnings and asset values. These
interactions have produced a volatile situation that has made forecasting the course of the
economy even more difficult than usual.
In my remarks today I will provide some perspective on recent developments in the economy
and financial markets, focusing on conditions in the United States. I will then discuss the
Fed's recent policy actions and our plans for addressing the economic and financial
challenges ahead.
Housing, the subprime mortgage market, and the financial turmoil
As you will recall, the U.S. economy experienced a mild recession in 2001. During the
ensuing recovery, above-trend growth was accompanied by rising rates of resource
utilization, particularly after the expansion picked up steam in mid-2003. Notably, the civilian
unemployment rate declined from a high of 6.3 percent in June 2003 to 4.4 percent in March
2007. As the economy approached full employment, the Federal Open Market Committee
(FOMC), the monetary policymaking arm of the Federal Reserve System, was faced with the
classic problem of managing the mid-cycle slowdown - that is, of setting policy to help guide
the economy toward sustainable growth without inflation. With that objective, the FOMC
implemented a sequence of rate increases, beginning in mid-2004 and ending in June 2006,
at which point the target for the federal funds rate was 5.25 percent - a level that, in the
judgment of the Committee, would best promote the policy objectives given to us by the
Congress. The economy continued to perform well into 2007, with solid growth through the
third quarter and unemployment remaining near recent lows. Indicators of the underlying
inflation trend, such as core inflation, showed signs of moderating.
However, the situation was complicated by a number of factors. Continued increases in the
prices of energy and other commodities, together with high levels of resource utilization, kept
the Committee on inflation alert. But perhaps an even greater challenge was posed by a
sharp and protracted correction in the U.S. housing market, which followed a multiyear boom
in housing construction and house prices. Indicating the depth of the decline in housing,
according to the most recent available data, housing starts and new home sales have both
fallen by about 50 percent from their respective peaks.
In all likelihood, the housing contraction would have been considerably milder had it not been
for adverse developments in the subprime mortgage market. Since early 2007, financial
market participants have been focused on the high and rising delinquency rates of subprime
mortgages, especially those with adjustable interest rates (subprime ARMs). Currently, about
21 percent of subprime ARMs are ninety days or more delinquent, and foreclosure rates are
rising sharply.
Although poor underwriting and, in some cases, fraud and abusive practices contributed to
the high rates of delinquency that we are now seeing in the subprime ARM market, the more
fundamental reason for the sharp deterioration in credit quality was the flawed premise on
which much subprime ARM lending was based: that house prices would continue to rise
rapidly. When house prices were increasing at double-digit rates, subprime ARM borrowers
were able to build equity in their homes during the period in which they paid a (relatively) low
introductory (or "teaser") rate on their mortgages. Once sufficient equity had been
accumulated, borrowers were often able to refinance, avoiding the increased payments
associated with the reset in the rate on the original mortgages. However, when declining
affordability finally began to take its toll on the demand for homes and thus on house prices,
borrowers could no longer rely on home-price appreciation to build equity; they were
accordingly unable to refinance and found themselves locked into their subprime ARM
contracts. Many of these borrowers found it difficult to make payments at even the
introductory rate, much less at the higher post-adjustment rate. The result, as I have already
noted, has been rising delinquencies and foreclosures, which will have adverse effects for
communities and the broader economy as well as for the borrowers themselves.
One of the many unfortunate consequences of these events, which may be with us for some
time, is on the availability of credit for nonprime borrowers. Ample evidence suggests that
responsible nonprime lending can be beneficial and safe for the borrower as well as
profitable for the lender. For example, even as delinquencies on subprime ARMs have
soared, loss rates on subprime mortgages with fixed interest rates, though somewhat higher
recently, remain in their historical range. Some lenders, including some who have worked
closely with nonprofit groups with strong roots in low-to-moderate-income communities, have
been able to foster homeownership in those communities while experiencing exceptionally
low rates of default. Unfortunately, at this point, the market is not discriminating to any
significant degree between good and bad nonprime loans, and few new loans are being
made.
Although subprime borrowers and the investors who hold these mortgages are the parties
most directly affected by the collapse of this market, the consequences have been felt much
more broadly. I have already referred to the role that the subprime crisis has played in the
housing correction. On the way up, expansive subprime lending increased the effective
demand for housing, pushing up prices and stimulating construction activity. On the way
down, the withdrawal of this source of demand for housing has exacerbated the downturn,
adding to the sharp decline in new homebuilding and putting downward pressure on house
prices. The addition of foreclosed properties to the inventories of unsold homes is further
weakening the market.
As you know, the losses in the subprime mortgage market also triggered a substantial
reaction in other financial markets. At some level, the magnitude of that reaction might be
deemed surprising, given the small size of the U.S. subprime market relative to world
financial markets. Part of the explanation for the outsized effect may be that, following a
period of more-aggressive risk-taking, the subprime crisis led investors to reassess credit
risks more broadly and, perhaps, to become less willing to take on risks of any type.
Investors have also been concerned that, by further weakening the housing sector, the
problems in the subprime mortgage market may lead overall economic growth to slow.
However, part of the explanation for the far-reaching financial impact of the subprime shock
is that it has contributed to a considerable increase in investor uncertainty about the
appropriate valuations of a broader range of financial assets, not just subprime mortgages.
For example, subprime mortgages were often combined with other types of loans in so-called
structured credit products. These investment products, sometimes packaged with various
credit and liquidity guarantees obtained from banks or through derivative contracts, were
divided into portions, or tranches, of varying seniority and credit quality. Thus, through
financial engineering, a diverse combination of underlying credits became the raw material
for a new set of financial assets, many of them garnering high ratings from credit agencies,
which could be matched to the needs of ultimate investors.
The complexity of structured credit products, as well as the difficulty of determining the
values of some of the underlying assets, led many investors to rely heavily on the
evaluations of these products by credit-rating agencies. However, as subprime mortgage
losses rose to levels that threatened even highly rated tranches, investors began to question
the reliability of the credit ratings and became increasingly unwilling to hold these products.
Similar concerns arose in the market for asset-backed commercial paper (ABCP). In this
market, various institutions established special-purpose vehicles to issue commercial paper
to help fund a variety of assets, including some private-label mortgage-backed securities,
mortgages warehoused for securitization, and other long-maturity assets. Investors had
typically viewed the commercial paper backed by these assets as quite safe and liquid. But
the concerns about mortgage-backed securities and structured credit products more
generally (even those unrelated to mortgages) led to great reluctance on the part of investors
to roll over ABCP, particularly at maturities of more than a few days, leaving the sponsors of
the various investment vehicles scrambling for liquidity. Those who could not find new
funding were forced to sell assets into a highly illiquid and unreceptive market.
Importantly, investors' loss of confidence was not restricted to securities related to subprime
mortgages but extended to other key asset classes. Notably, the secondary market for
private-label securities backed by prime jumbo mortgages has also contracted, and issuance
of such securities has dwindled.1 Even though default rates on prime jumbo mortgages have
remained very low, the experience with subprime mortgages has evidently made investors
more sensitive to the risks associated with other housing-related assets as well. Other types
of assets that have seen a cooling of investor interest include loans for commercial real
estate projects and so-called leveraged loans, which are used to finance mergers and
leveraged buyouts.
Although structured credit products and special-purpose investment vehicles may be viewed
as providing direct channels between the ultimate borrowers and the broader capital
markets, thereby circumventing the need for traditional bank financing, banks nevertheless
played important roles in this mode of finance. Large money-center banks and other major
financial institutions (which I will call "banks," for short) underwrote many of the loans and
created many of the structured credit products that were sold into the market. Banks also
supported the various investment vehicles in many ways, for example, by serving as advisers
and by providing standby liquidity facilities and various credit enhancements. As the
problems with these facilities multiplied, banks came under increasing pressure to rescue the
investment vehicles they sponsored - either by providing liquidity or other support or, as has
become increasingly the norm, by taking the assets of the off-balance-sheet vehicles onto
their own balance sheets. Banks' balance sheets were swelled further by non-conforming
mortgages, leveraged loans, and other credits that the banks had extended but for which
well-functioning secondary markets no longer existed.
Even as their balance sheets expanded, banks began to report large losses, reflecting the
sharp declines in the values of mortgages and other assets. Thus, banks too became subject
to valuation uncertainty, as could be seen in their share prices and other market indicators
such as quotes on credit default swaps. The combination of larger balance sheets and
unexpected losses also resulted in a decline in the capital ratios of a number of institutions.
Several have chosen to raise new capital in response, and the banking system retains
substantial levels of capital. However, on balance, these developments have prompted
banks to become protective of their liquidity and balance sheet capacity and thus to become
less willing to provide funding to other market participants, including other banks. As a result,
both overnight and term interbank funding markets have periodically come under
considerable pressure, with spreads on interbank lending rates over various benchmark
rates rising notably. We also see considerable evidence that banks have become more
restrictive in their lending to firms and households. More-expensive and less-available credit
seems likely to impose a measure of financial restraint on economic growth.
The recent developments in U.S. and foreign financial markets will stimulate considerable
review and analysis in the months and years to come. Around the world, legislatures,
regulators, supervisors, accounting boards, central banks, and others with responsibility for
oversight of the financial system are already hard at work trying to distill the lessons to be
drawn from this experience and their implications for policy. Many in the private sector,
including banks, credit-rating agencies, and the investment community, are likewise actively
reviewing and responding to these developments. Some of the areas that will draw scrutiny
are the appropriate use of credit ratings by investors, banks, and supervisors; the need for
enterprise-wide, better-integrated risk-management techniques in large financial institutions;
the appropriateness of accounting rules governing asset valuation and the use of
offbalance-sheet vehicles; and weaknesses in the originate-to-distribute model and in the
design of structured credit products, among many others. In the longer term, the response of
the public and private sectors to this experience should help create a stronger financial
system.
The Federal Reserve's response
Fortunately, after a number of years of strong earnings, most financial institutions entered the
current episode in good financial condition. Thus, notwithstanding the effects of multi-billion
dollar write-downs on the earnings and share prices of some large institutions, the banking
system remains sound. Nevertheless, the market strains have been serious, and they
continue to pose risks to the broader economy. The Federal Reserve accordingly has taken
a number of steps to help markets return to more orderly functioning and to foster its
macroeconomic objectives of maximum sustainable employment and price stability.
Broadly, the Federal Reserve's response has followed two tracks: efforts to support market
liquidity and functioning and the pursuit of our macroeconomic objectives through monetary
policy.
To help address the significant strains in short-term money markets, the Federal Reserve
has taken a range of steps. Notably, on August 17, the Federal Reserve Board cut the
discount rate - the rate at which it lends directly to banks - by 50 basis points, or 1/2
percentage point, and it has since maintained the spread between the federal funds rate and
the discount rate at 50 basis points, rather than the customary 100 basis points.2 The Fed
also adjusted its usual practices to facilitate the provision of discount window financing for as
long as thirty days, renewable at the request of the borrower. Loans through the discount
window differ from conventional open market operations in that the loans can be made
directly to individual banks. In contrast, open market operations are arranged with a limited
set of dealers of government securities. In addition, whereas open market operations involve
lending against government and agency securities, loans through the discount window can
be made against a much wider range of collateral.
The changes to the discount window were designed to assure banks of the availability of a
backstop source of liquidity. Although banks borrowed only moderate amounts at the
discount window, they substantially increased the amount of collateral they placed with
Reserve Banks. This and other factors suggest that these changes to the discount window
facility, together with the statements and actions of the FOMC, had some positive influence
on market conditions.
However, as a tool for easing the strains in money markets, the discount window has two
drawbacks. First, banks may be reluctant to use the window, fearing that markets will draw
adverse inferences about their financial condition and access to private sources of funding -
the so-called stigma problem. Second, to maintain the federal funds rate near its target, the
Federal Reserve System's open market desk must take into account the fact that loans
through the discount window add reserves to the banking system and thus, all else equal,
could tend to push the federal funds rate below the target set by the FOMC. The open
market desk can offset this effect by draining reserves from the system. But the amounts that
banks choose to borrow at the discount window can be difficult to predict, complicating the
management of the federal funds rate, especially when borrowings are large.
To address the limitations of the discount window, the Federal Reserve recently introduced a
term auction facility, or TAF, through which prespecified amounts of discount window credit
can be auctioned to eligible borrowers. As I will discuss in greater detail in a moment, our
intention in developing the TAF was to provide a tool that could more effectively address the
problems currently affecting the interbank lending market without complicating the
administration of reserves and the federal funds rate. In December, the Fed successfully
auctioned $40 billion through this facility and, as part of a coordinated operation, the
European Central Bank and the Swiss National Bank lent an additional $24 billion. These two
central banks obtained the dollars from the Federal Reserve through currency swaps
(essentially, two-way lines of credit in which each central bank agrees to lend the other up to
a fixed amount in its own currency). As part of the same coordinated action, the central
banks of the United Kingdom and Canada conducted similar operations in their own
currencies. On January 4, the Federal Reserve announced that we will auction an additional
$60 billion in twenty-eight-day credit through the TAF, to be spread across two auctions that
will be held later this month. With these actions and the passage of the year end, term
premiums in the interbank market and some other measures of strains in funding markets
have eased significantly, though they remain well above levels prevailing before August last
year.
Based on our initial experience, it appears that the TAF may have overcome the two
drawbacks of the discount window, in that there appears to have been little if any stigma
associated with participation in the auction, and - because the Fed was able to set the
amounts to be auctioned in advance - the open market desk faced minimal uncertainty about
the effects of the operation on bank reserves. The TAF may thus become a useful
permanent addition to the Fed's toolbox.3 TAF auctions will continue as long as necessary to
address elevated pressures in short-term funding markets, and we will continue to work
closely and cooperatively with other central banks to address market strains that could
hamper the achievement of our broader economic objectives.
Although the TAF and other liquidity-related actions appear to have had some positive
effects, such measures alone cannot fully address fundamental concerns about credit quality
and valuation, nor do these actions relax the balance sheet constraints on financial
institutions. Hence, they cannot eliminate the financial restraints affecting the broader
economy. Monetary policy (that is, the management of the short-term interest rate) is the
Fed's best tool for pursuing our macroeconomic objectives, namely to promote maximum
sustainable employment and price stability.
Although economic growth slowed in the fourth quarter of last year from the third quarter's
rapid clip, it seems nonetheless, as best we can tell, to have continued at a moderate pace.
Recently, however, incoming information has suggested that the baseline outlook for real
activity in 2008 has worsened and the downside risks to growth have become more
pronounced. Notably, the demand for housing seems to have weakened further, in part
reflecting the ongoing problems in mortgage markets. In addition, a number of factors,
including higher oil prices, lower equity prices, and softening home values, seem likely to
weigh on consumer spending as we move into 2008.
Financial conditions continue to pose a downside risk to the outlook for growth. Market
participants still express considerable uncertainty about the appropriate valuation of complex
financial assets and about the extent of additional losses that may be disclosed in the future.
On the whole, despite improvements in some areas, the financial situation remains fragile,
and many funding markets remain impaired. Adverse economic or financial news has the
potential to increase financial strains and to lead to further constraints on the supply of credit
to households and businesses. I expect that financial-market participants - and, of course,
the Committee - will be paying particular attention to developments in the housing market, in
part because of the potential for spillovers from housing to other sectors of the economy.
A second consequential risk to the growth outlook concerns the performance of the labor
market. Last week's report on labor-market conditions in December was disappointing, as it
showed an increase of 0.3 percentage point in the unemployment rate and a decline in
private payroll employment. Heretofore, the labor market has been a source of stability in the
macroeconomic situation, with relatively steady gains in wage and salary income providing
households the wherewithal to support moderate growth in real consumption spending. It
would be a mistake to read too much into any one report. However, should the labor market
deteriorate, the risks to consumer spending would rise.
Even as the outlook for real activity has weakened, there have been some important
developments on the inflation front. Most notably, the same increase in oil prices that may be
a negative influence on growth is also lifting overall consumer prices and probably putting
some upward pressure on core inflation measures as well. Last year, food prices also
increased exceptionally rapidly by recent standards, further boosting overall consumer price
inflation. Thus far, inflation expectations appear to have remained reasonably well anchored,
and pressures on resource utilization have diminished a bit. However, any tendency of
inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be
eroded could greatly complicate the task of sustaining price stability and reduce the central
bank's policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months
ahead we will be closely monitoring the inflation situation, particularly as regards inflation
expectations.
Monetary policy has responded proactively to evolving conditions. As you know, the
Committee cut its target for the federal funds rate by 50 basis points at its September
meeting and by 25 basis points each at the October and December meetings. In total,
therefore, we have brought the funds rate down by a percentage point from its level just
before financial strains emerged. The Federal Reserve took these actions to help offset the
restraint imposed by the tightening of credit conditions and the weakening of the housing
market. However, in light of recent changes in the outlook for and the risks to growth,
additional policy easing may well be necessary. The Committee will, of course, be carefully
evaluating incoming information bearing on the economic outlook. Based on that evaluation,
and consistent with our dual mandate, we stand ready to take substantive additional action
as needed to support growth and to provide adequate insurance against downside risks.
Financial and economic conditions can change quickly. Consequently, the Committee must
remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and,
in particular, to counter any adverse dynamics that might threaten economic or financial
stability.