Ben S Bernanke: Remarks on the economic outlook
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the International Monetary Conference, Barcelona, Spain (via satellite),
3 June 2008.
* * *
As you know, financial markets in the United States and in a number of other industrialized
countries have been under considerable strain since late last summer. Financial market
conditions have in turn affected economic prospects, most notably by affecting the cost and
availability of new credit.
Much discussion of the turmoil has focused on problems that have arisen with respect to
specific financial markets and financial instruments. Understanding these institutional details
is, of course, essential to the task of restoring more normal functioning to the financial
system. Stepping back, however, one can see - at least in retrospect - that the turmoil has
been some time in the making and reflects the combined influence of several powerful,
longer-term developments.
Today, I will briefly discuss some longer-term factors that underlie recent developments;
trace how these factors, individually and in combination, have affected both the financial
markets and the economy; and describe how the Federal Reserve has responded to the
challenges we face.
The sources of the financial turmoil: a longer-term perspective
Although the severity of the financial stresses became apparent only in August, several
longer-term developments served as prologue for the recent turmoil and helped bring us to
the current situation.
The first of these was the U.S. housing boom, which began in the mid-1990s and picked up
steam around 2000. Between 1996 and 2005, house prices nationwide increased about 90
percent. During the years from 2000 to 2005 alone, house prices increased by roughly 60
percent - far outstripping the increases in incomes and general prices - and single-family
home construction increased by about 40 percent. But, as you know, starting in 2006, the
boom turned to bust. Over the past two years, building activity has fallen by more than half
and now is well below where it was in 2000. House prices have shown significant declines in
many areas of the country.
A second critical development was an even broader credit boom, in which lenders and
investors aggressively sought out new opportunities to take credit risk even as market risk
premiums contracted. Aspects of the credit boom included rapid growth in the volumes of
private equity deals and leveraged lending and the increased use of complex and often
opaque investment vehicles, including structured credit products. The explosive growth of
subprime mortgage lending in recent years was yet another facet of the broader credit boom.
Expanding access to homeownership is an important social goal, and responsible subprime
lending is beneficial for both borrowers and lenders. But, clearly, much of the subprime
lending that took place during the latter stages of the credit boom in 2005 and 2006 was
done very poorly.
A third longer-term factor contributing to recent financial and economic developments is the
unprecedented growth in developing and emerging market economies. From the U.S.
perspective, this growth has been a double-edged sword. On the one hand, low-cost imports
from emerging markets for many years increased U.S. living standards and made the Fed's
job of managing inflation easier. Moreover, currently, the demand for U.S. exports arising
from strong global growth has been an important offset to the factors restraining domestic
demand, including housing and tight credit. On the other hand, the rapid growth in the
emerging markets and the associated sharp rise in their demand for raw materials have been
- together with a variety of constraints on supply - a major cause of the escalation in the
relative prices of oil and other commodities, which has placed intense economic pressure on
many U.S. households and businesses.
In the financial sphere, the three longer-term developments I have identified are linked by the
fact that a substantial increase in the net supply of saving in emerging market economies
contributed to both the U.S. housing boom and the broader credit boom.1 The sources of this
increase in net saving included rapid growth in high-saving East Asian countries and, outside
of China, reduced investment rates in that region; large buildups in foreign exchange
reserves in a number of emerging markets; and the enormous increases in the revenues
received by exporters of oil and other commodities. The pressure of these net savings flows
led to lower long-term real interest rates around the world, stimulated asset prices (including
house prices), and pushed current accounts toward deficit in the industrial countries -
notably the United States - that received these flows.
To be sure, the large inflows of savings and low global interest rates presented a valuable
opportunity to the recipient countries, provided they invested the inflows wisely.
Unfortunately, this did not always occur, as an increased appetite for risk-taking - a
"reaching for yield" - stimulated some financial innovations and lending practices that proved
imprudent or otherwise questionable. Regulators identified some of these issues in real time;
for example, federal banking regulators issued new guidance on nontraditional mortgage
lending and on commercial real estate lending. The Federal Reserve, in cooperation with the
other supervisors, encouraged improvements in market infrastructure and conducted a series
of targeted reviews designed to improve risk-management practice with respect to
derivatives, exposures to hedge funds, leveraged lending, and other areas. And, in
preparation for the new Basel II capital regulations, supervisors required more-demanding
standards for the measurement and management of risk. Despite these efforts, however, the
risk-management systems of many financial institutions proved inadequate in the face of a
major housing downturn and substantial disruptions in market liquidity.
The current economic and financial situation reflects, in significant part, the unwinding of two
of these longer-term developments - the housing boom and the credit boom - and the
continuation of the pressure of global demand on commodity prices.
The housing boom came to an end because rising prices made housing increasingly
unaffordable. The end of rapid house price increases in turn undermined a basic premise of
many adjustable-rate subprime loans - that home price appreciation alone would always
generate enough equity to permit the borrower to refinance and thereby avoid ever having to
pay the fully-indexed interest rate. When that premise was shown to be false and defaults on
subprime mortgages rose sharply, investors quickly backpedaled from mortgage-related
securities. The reduced availability of mortgage credit caused housing to weaken further.
The losses from subprime mortgages have been significant in themselves, but their greater
impact was to trigger the end of the broader credit boom. Notably, as subprime losses forced
the credit rating agencies to downgrade what had been highly rated mortgage-backed
securities, investors also came to doubt the reliability of ratings that had been awarded to
other highly complex securities. As a result, investors became much more cautious and
reversed their aggressive risk-taking of the credit boom period. The resulting pullback
affected a much broader range of securities, including leveraged and syndicated loans,
asset-backed commercial paper, commercial mortgage-backed securities, and a variety of
structured credit products. Large financial institutions, especially in the United States and
Europe, were particularly affected by these events, having reported a total of roughly $300
billion in writedowns and credit losses. These institutions have also been forced to bring onto
their balance sheets the assets of sponsored investment vehicles that can no longer be
financed on a standalone basis. Fortunately, most financial institutions entered this episode
with strong capital positions, and many have raised substantial amounts of new capital. Still,
balance sheet pressures and the relatively high cost of new bank capital have reduced the
willingness and ability of these institutions to make markets and extend new credit.
Prospectively, financial conditions seem likely to be closely tied to both domestic and global
economic developments, including the course of the prices of oil and other commodities.
This brief overview makes clear that both global and domestic factors have played important
roles in recent developments in the United States. The housing and credit booms were
driven to some extent by global savings flows, but they also reflected domestic factors, such
as weaknesses in risk measurement and management and lax standards in subprime
lending. Higher commodity prices are for the most part a global phenomenon, but U.S.
dependence on oil imports makes this country quite vulnerable on that score.
The outlook
With this broader perspective as background, I turn now to a brief discussion of the current
situation and outlook. Broadly speaking, the functioning of financial markets has improved of
late, but conditions remain strained and some key funding and securitization markets have
shown only tentative signs of recovery. Some borrowers, such as highly-rated corporations,
retain good access to credit, but credit conditions generally remain restrictive in areas related
to residential or commercial real estate.
Residential construction continues to contract, and the overhang of unsold new homes
remains large, although it has declined some in absolute terms. Consumer spending has
thus far held up a bit better than expected, but households continue to face significant
headwinds, including falling house prices, a softer job market, tighter credit, and higher
energy prices, and consumer sentiment has declined sharply since the fall. Businesses are
also facing challenges, including rapidly escalating costs of raw materials and weaker
domestic demand. However, the strength of foreign demand for U.S. goods and services has
offset, to some extent, the slowing of domestic sales.
Overall economic growth was quite slow but apparently positive in both the fourth quarter of
2007 and the first quarter of this year. Activity during the current quarter is also likely to be
relatively weak. We may see somewhat better economic conditions during the second half of
2008, reflecting the effects of monetary and fiscal stimulus, reduced drag from residential
construction, further progress in the repair of financial and credit markets, and still solid
demand from abroad. This baseline forecast is consistent with our recently released
projections, which also see growth picking up further in 2009. However, until the housing
market, and particularly house prices, shows clearer signs of stabilization, growth risks will
remain to the downside. Recent increases in oil prices pose additional downside risks to
growth.
Inflation has remained high, largely reflecting continued sharp increases in the prices of
globally traded commodities. Thus far, the pass-through of high raw materials costs to
domestic labor costs and the prices of most other products has been limited, in part because
of softening domestic demand. However, the continuation of this pattern is not guaranteed
and will bear close attention. Futures markets continue to predict - albeit with a great range
of uncertainty - that commodity prices will level out, a forecast consistent with our
expectation of some overall slowing in the global economy and thus in the demand for raw
materials. A rough stabilization of commodity prices, even at high levels, would result in a
relatively rapid moderation of inflation, consistent with the projections of Federal Reserve
governors and Reserve Bank presidents for 2009 and 2010. Unfortunately, the prices of a
number of commodities, most notably oil, have continued upward recently, even as
expectations of future policy rates and the foreign exchange value of the dollar have
remained generally stable in the past few months. The possibility that commodity prices will
continue to rise is an important risk to the inflation forecast. Another significant upside risk to
inflation is that high headline inflation, if sustained, might lead the public to expect higher
long-term inflation rates, an expectation that could ultimately become self-confirming.
The Federal Reserve's policy response
The Federal Reserve's mandate is to foster maximum sustainable employment and price
stability. To achieve these goals, we must also support the return of financial markets to
more normal functioning.
The Federal Reserve is pursuing its objectives through several means. First, we have eased
monetary policy substantially and proactively to address the sharp deterioration in financial
conditions and to forestall some of the potential adverse effects on the broader economy.
Our decisive policy actions were premised on the view that a more gradual reduction in
short-term rates could well have failed to contain the financial and economic problems
confronting us. For now, policy seems well positioned to promote moderate growth and price
stability over time. We will, of course, be watching the evolving situation closely and are
prepared to act as needed to meet our dual mandate.
In collaboration with our colleagues at the Treasury, we continue to carefully monitor
developments in foreign exchange markets. The challenges that our economy has faced
over the past year or so have generated some downward pressures on the foreign exchange
value of the dollar, which have contributed to the unwelcome rise in import prices and
consumer price inflation. We are attentive to the implications of changes in the value of the
dollar for inflation and inflation expectations and will continue to formulate policy to guard
against risks to both parts of our dual mandate, including the risk of an erosion in longer-term
inflation expectations. Over time, the Federal Reserve's commitment to both price stability
and maximum sustainable employment and the underlying strengths of the U.S. economy -
including flexible markets and robust innovation and productivity - will be key factors
ensuring that the dollar remains a strong and stable currency.
Second, to improve market liquidity and functioning, we have taken a range of measures to
ensure that financial institutions have adequate access to central bank liquidity.2 The
resulting reductions in funding pressures, together with the increased confidence created by
the assurance that backstop liquidity is available to eligible institutions, should help to
promote an orderly resolution of current market dislocations. In recognition of the global
nature of financial markets, we have also cooperated with other major central banks to
ensure that central bank liquidity is deployed where needed.
Finally, we are taking action in our role as regulators. We have worked with lenders and
servicers to encourage appropriate modifications of distressed mortgage loans, and we have
proposed new rules to improve disclosure and to ban unfair or deceptive acts and practices
in mortgage lending. We are also collaborating with other regulators, both domestically and
abroad, to put in place changes that will help make the financial system less vulnerable in the
future. Among the changes we expect to see are strengthening of capital and liquidity rules,
greater disclosure requirements, an increased emphasis on the measurement and
management of firmwide risks, and further steps to increase the transparency and resilience
of the financial infrastructure. Our goal is to emerge from this difficult period with a financial
system that will be more stable without being less innovative, with a more effective balance
between market discipline and regulation.
References
Bernanke, Ben S. (2005). "The Global Saving Glut and the U.S. Current Account Deficit,"
speech delivered at the Homer Jones Lecture, Federal Reserve Bank of St. Louis, St. Louis,
Mo., April 14.
Bernanke, Ben S. (2008). "Liquidity Provision by the Federal Reserve," speech delivered at
the Federal Reserve Bank of Atlanta Financial Markets Conference, Sea Island, Ga., May
13.