Ben S Bernanke: Economic outlook
Testimony of Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, before the Joint Economic Committee, US Congress, Washington DC,
24 September 2008.
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Chairman Schumer, Vice Chair Maloney, Representative Saxton, and other members of the
committee, I appreciate this opportunity to discuss recent developments in financial markets
and to present an update on the economic situation. As you know, the U.S. economy
continues to confront substantial challenges, including a weakening labor market and
elevated inflation. Notably, stresses in financial markets have been high and have recently
intensified significantly. If financial conditions fail to improve for a protracted period, the
implications for the broader economy could be quite adverse.
The downturn in the housing market has been a key factor underlying both the strained
condition of financial markets and the slowdown of the broader economy. In the financial
sphere, falling home prices and rising mortgage delinquencies have led to major losses at
many financial institutions, losses only partially replaced by the raising of new capital.
Investor concerns about financial institutions increased over the summer, as
mortgagerelated assets deteriorated further and economic activity weakened. Among the firms under
the greatest pressure were Fannie Mae and Freddie Mac, Lehman Brothers, and, more
recently, American International Group (AIG). As investors lost confidence in them, these
companies saw their access to liquidity and capital markets increasingly impaired and their
stock prices drop sharply.
The Federal Reserve believes that, whenever possible, such difficulties should be addressed
through private-sector arrangements - for example, by raising new equity capital, by
negotiations leading to a merger or acquisition, or by an orderly wind-down. Government
assistance should be given with the greatest of reluctance and only when the stability of the
financial system, and, consequently, the health of the broader economy, is at risk. In the
cases of Fannie Mae and Freddie Mac, however, capital raises of sufficient size appeared
infeasible and the size and government-sponsored status of the two companies precluded a
merger with or acquisition by another company. To avoid unacceptably large dislocations in
the financial sector, the housing market, and the economy as a whole, the Federal Housing
Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship, and the
Treasury used its authority, granted by the Congress in July, to make available financial
support to the two firms. The Federal Reserve, with which FHFA consulted on the
conservatorship decision as specified in the July legislation, supported these steps as
necessary and appropriate. We have seen benefits of this action in the form of lower
mortgage rates, which should help the housing market.
The Federal Reserve and the Treasury attempted to identify private-sector solutions for AIG
and Lehman Brothers, but none was forthcoming. In the case of AIG, the Federal Reserve,
with the support of the Treasury, provided an emergency credit line to facilitate an orderly
resolution. The Federal Reserve took this action because it judged that, in light of the
prevailing market conditions and the size and composition of AIG's obligations, a disorderly
failure of AIG would have severely threatened global financial stability and, consequently, the
performance of the U.S. economy. To mitigate concerns that this action would exacerbate
moral hazard and encourage inappropriate risk-taking in the future, the Federal Reserve
ensured that the terms of the credit extended to AIG imposed significant costs and
constraints on the firm's owners, managers, and creditors. The chief executive officer has
been replaced. The collateral for the loan is the company itself, together with its
subsidiaries.1 (Insurance policyholders and holders of AIG investment products are,
however, fully protected.) Interest will accrue on the outstanding balance of the loan at a rate
of three-month Libor plus 850 basis points, implying a current interest rate over 11 percent.
In addition, the U.S. government will receive equity participation rights corresponding to a
79.9 percent equity interest in AIG and has the right to veto the payment of dividends to
common and preferred shareholders, among other things.
In the case of Lehman Brothers, a major investment bank, the Federal Reserve and the
Treasury declined to commit public funds to support the institution. The failure of Lehman
posed risks. But the troubles at Lehman had been well known for some time, and investors
clearly recognized - as evidenced, for example, by the high cost of insuring Lehman's debt in
the market for credit default swaps - that the failure of the firm was a significant possibility.
Thus, we judged that investors and counterparties had had time to take precautionary
measures.
While perhaps manageable in itself, Lehman's default was combined with the unexpectedly
rapid collapse of AIG, which together contributed to the development last week of
extraordinarily turbulent conditions in global financial markets. These conditions caused
equity prices to fall sharply, the cost of short-term credit - where available - to spike upward,
and liquidity to dry up in many markets. Losses at a large money market mutual fund sparked
extensive withdrawals from a number of such funds. A marked increase in the demand for
safe assets - a flight to quality - sent the yield on Treasury bills down to a few hundredths of
a percent. By further reducing asset values and potentially restricting the flow of credit to
households and businesses, these developments pose a direct threat to economic growth.
The Federal Reserve took a number of actions to increase liquidity and stabilize markets.
Notably, to address dollar funding pressures worldwide, we announced a significant
expansion of reciprocal currency arrangements with foreign central banks, including an
approximate doubling of the existing swap lines with the European Central Bank and the
Swiss National Bank and the authorization of new swap facilities with the Bank of Japan, the
Bank of England, and the Bank of Canada, among others. We will continue to work closely
with colleagues at other central banks to address ongoing liquidity pressures. The Federal
Reserve also announced initiatives to assist money market mutual funds facing heavy
redemptions and to increase liquidity in short-term credit markets.
Despite the efforts of the Federal Reserve, the Treasury, and other agencies, global financial
markets remain under extraordinary stress. Action by the Congress is urgently required to
stabilize the situation and avert what otherwise could be very serious consequences for our
financial markets and for our economy. In this regard, the Federal Reserve supports the
Treasury's proposal to buy illiquid assets from financial institutions. Purchasing impaired
assets will create liquidity and promote price discovery in the markets for these assets, while
reducing investor uncertainty about the current value and prospects of financial institutions.
More generally, removing these assets from institutions' balance sheets will help to restore
confidence in our financial markets and enable banks and other institutions to raise capital
and to expand credit to support economic growth.
I will now turn to a brief update on the economic situation.
Ongoing developments in financial markets are directly affecting the broader economy
through several channels, most notably by restricting the availability of credit. Mortgage
credit terms have tightened significantly and fees have risen, especially for potential
borrowers who lack substantial down payments or who have blemished credit histories.
Mortgages that are ineligible for credit guarantees by Fannie Mae or Freddie Mac - for
example, nonconforming jumbo mortgages - cannot be securitized and thus carry much
higher interest rates than conforming mortgages. Some lenders have reduced borrowing
limits on home equity lines of credit. Households also appear to be having more difficulty of
late in obtaining nonmortgage credit. For example, the Federal Reserve's Senior Loan Officer
Opinion Survey reported that as of July an increasing proportion of banks had tightened
standards for credit card and other consumer loans. In the business sector, through August,
the financially strongest firms remained able to issue bonds but bond issuance by
speculative-grade firms remained very light. More recently, however, deteriorating financial
market conditions have disrupted the commercial paper market and other forms of financing
for a wide range of firms, including investment-grade firms. Financing for commercial real
estate projects has also tightened very significantly.
When worried lenders tighten credit, then spending, production, and job creation slow. Real
economic activity in the second quarter appears to have been surprisingly resilient, but, more
recently, economic activity appears to have decelerated broadly. In the labor market, private
payrolls shed another 100,000 jobs in August, bringing the cumulative drop since November
to 770,000. New claims for unemployment insurance are at elevated levels and the civilian
unemployment rate rose to 6.1 percent in August. Households' real disposable income was
boosted significantly in the spring by the tax rebate payments, but, excluding those
payments, real after-tax income has fallen this year, which partly reflects increases in the
prices of energy and food.
In recent months, the weakness in real income together with the restraining effects of
reduced credit flows and declining financial and housing wealth have begun to show through
more clearly to consumer spending. Real personal consumption expenditures for goods and
services declined in June and July, and the retail sales report for August suggests that
outlays for consumer goods fell noticeably further last month. Although the retrenchment in
household spending has been widespread, purchases of motor vehicles have dropped off
particularly sharply. On a more positive note, oil and gasoline prices - while still at high
levels, in part reflecting the effects of Hurricane Ike - have come down substantially from the
peaks they reached earlier this summer, contributing to a recent improvement in consumer
confidence. However, the weakness in the fundamentals underlying consumer spending
suggest that household expenditures will be sluggish, at best, in the near term.
The recent indicators of the demand for new and existing homes hint at some stabilization of
sales, and lower mortgage rates are likely to provide some support for demand in coming
months. Moreover, although expectations that house prices will continue to fall have probably
dissuaded some potential buyers from entering the market, lower house prices and mortgage
interest rates are making housing increasingly affordable over time. Still, homebuilders retain
large backlogs of unsold homes, which should continue to restrain the pace of new home
construction. Indeed, single-family housing starts and new permit issuance dropped further in
August. At the same time, the continuing decline in house prices reduces homeowners'
equity and puts continuing pressure on the balance sheets of financial institutions, as I have
already noted.
As of midyear, business investment was holding up reasonably well, with investment in
nonresidential structures particularly robust. However, a range of factors, including
weakening fundamentals and constraints on credit, are likely to result in a considerable
slowdown in the construction of commercial and office buildings in coming quarters.
Business outlays for equipment and software also appear poised to slow in the second half
of this year, assuming that production and sales slow as anticipated.
International trade provided considerable support for the U.S. economy over the first half of
the year. Economic activity has been buoyed by strong foreign demand for a wide range of
U.S. exports, including agricultural products, capital goods, and industrial supplies, even as
imports declined. However, in recent months, the outlook for foreign economic activity has
deteriorated amid unsettled conditions in financial markets, troubled housing sectors, and
softening sentiment. As a consequence, in coming quarters, the contribution of net exports to
U.S. production is not likely to be as sizable as it was in the first half of the year.
All told, real gross domestic product is likely to expand at a pace appreciably below its
potential rate in the second half of this year and then to gradually pick up as financial
markets return to more-normal functioning and the housing contraction runs its course. Given
the extraordinary circumstances, greater-than-normal uncertainty surrounds any forecast of
the pace of activity. In particular, the intensification of financial stress in recent weeks, which
will make lenders still more cautious about extending credit to households and business,
could prove a significant further drag on growth. The downside risks to the outlook thus
remain a significant concern.
Inflation rose sharply over the period from May to July, reflecting rapid increases in energy
and food prices. During the same period, price inflation for goods and services other than
food and energy also moved up from the low rates seen in the spring, as the higher costs of
energy, other commodities, and imported goods were partially passed through to consumers.
Recently, however, the news on inflation has been more favorable. The prices of oil and
other commodities, while remaining quite volatile, have fallen, on net, from their recent
peaks, and the dollar is up from its mid-summer lows. The declines in energy prices have
also led to some easing of inflation expectations, as measured, for example, by consumer
surveys and the pricing of inflation-indexed Treasury securities.
If not reversed, these developments, together with a pace of growth that is likely to fall short
of potential for a time, should lead inflation to moderate later this year and next year.
Nevertheless, the inflation outlook remains highly uncertain. Indeed, the fluctuations in oil
prices in the past few days illustrate the difficulty of predicting the future course of commodity
prices. Consequently, the upside risks to inflation remain a significant concern as well.
Over time, a number of factors should promote the return of our economy to higher levels of
employment and sustainable growth with price stability, including the stimulus being provided
by monetary policy, lower oil and commodity prices, increasing stability in the mortgage and
housing markets, and the natural recuperative powers of our economy. However,
stabilization of our financial system is an essential precondition for economic recovery. I urge
the Congress to act quickly to address the grave threats to financial stability that we currently
face. For its part, the Federal Open Market Committee will monitor economic and financial
developments carefully and will act as needed to promote sustainable economic growth and
price stability.