Ben S Bernanke: Current economic and financial conditions
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the National Association for Business Economics 50th Annual Meeting,
Washington DC, 7 October 2008.
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Good afternoon. I am pleased to have once again the opportunity to address the National
Association for Business Economics. My remarks today will focus on recent developments in
the financial sector and the economy and on the challenges we face.
As you know, financial systems in the United States and in much of the rest of the world are
under extraordinary stress, particularly the credit and money markets. The losses suffered by
many banks and nonbank financial firms have both constrained their ability to lend and
reduced the willingness of other market participants to deal with them. Great uncertainty
about the values of financial assets, particularly more complex and opaque assets, has made
investors extremely reluctant to bear credit risk, resulting in further declines in asset prices
and a drying up of liquidity in a number of funding markets. Even secured funding has
become expensive and difficult to obtain, as lenders worry about their ability to sell collateral
in illiquid markets in the event of default. In addition, many securitization markets, such as
the secondary market for private-label mortgage-backed securities, remain closed or
impaired.
Considerable experience in both industrialized and emerging economies has shown that
severe financial instability, together with the associated declines in asset prices and
disruptions in credit markets, can take a heavy toll on the broader economy if left unchecked.
For this reason, the Federal Reserve, the Treasury, and other agencies are committed to
restoring market stability and are working assiduously to ensure that the financial system is
able to perform its critical economic functions. Recent actions by the Congress have given
the Treasury new tools and resources to address the stressed conditions of our financial
markets and institutions. The Federal Reserve has also been granted a new authority, the
ability to pay interest on bank reserves, which will allow us to expand our lending as needed
to support the system while better managing the federal funds rate. These tools will provide
important additional support for the government's efforts to strengthen financial markets and
the economy.
Let me briefly review recent financial developments. On the heels of nearly a year of stress in
credit markets, investors' and creditors' concerns about funding and credit risks at financial
firms intensified over the summer as mortgage-related assets deteriorated further, economic
growth slowed, and uncertainty about the economic outlook increased. As investors and
creditors lost confidence in the ability of certain firms to meet their obligations, their access to
capital markets as well as to short-term funding markets became increasingly impaired and
their stock prices fell sharply. Among the companies that experienced this dynamic most
forcefully were the government-sponsored enterprises (GSEs), Fannie Mae and Freddie
Mac; the investment bank Lehman Brothers; and the insurance company American
International Group (AIG).
The Federal Reserve believes that, whenever possible, such difficulties should be addressed
through private-sector arrangements - for example, by raising new equity capital, as many
firms have done, by negotiations leading to a merger or acquisition, or by an orderly
winddown. Government assistance should be provided with the greatest reluctance and only
when the stability of the financial system, and thus the health of the broader economy, is at
risk. In those cases when financial stability is threatened, however, intervention to protect the
public interest may well be justified.
Fannie Mae and Freddie Mac present cases in point. The Federal Reserve had long warned
about the systemic risks posed by these companies' large portfolios of mortgages and
mortgage-backed securities, as well as the problems arising from the conflict between
shareholders' objectives and the government's goals for the two firms. Given the scale of
losses in their portfolios, raising enough new capital from private investors was infeasible.
The firms' size and their government-sponsored status precluded a merger with, or
acquisition by, another company. To avoid unacceptably large dislocations in the mortgage
markets, the financial sector, and the economy as a whole, the Federal Housing Finance
Agency (FHFA) put Fannie and Freddie into conservatorship and the Treasury, drawing on
authorities recently granted by the Congress, made financial support available. The Federal
Reserve, acting in a consultative role, worked closely with FHFA in evaluating the GSE
portfolios and capital positions. Based on the joint findings of the agencies, we supported
FHFA's decision to place the companies into conservatorship as necessary and appropriate,
given their conditions and systemic importance. The government's actions appear to have
stabilized the GSEs, although like virtually all other firms they are experiencing effects of the
current crisis. Nonetheless, we already have seen benefits of their stabilization in the form of
lower mortgage rates, which should help the housing market.
The difficulties at Lehman and AIG raised somewhat different issues. Like the GSEs, both
companies were large and complex and deeply embedded in our financial system. In both
cases, as the firms approached default, the Treasury and the Federal Reserve sought
private-sector solutions, but none was forthcoming. Attempts to organize a consortium of
private firms to purchase or recapitalize Lehman were unsuccessful. With respect to
publicsector solutions, we determined that either facilitating a sale of Lehman or maintaining the
company as a free-standing entity would have required a very sizable injection of public
funds - much larger than in the case of Bear Stearns - and would have involved the
assumption by taxpayers of billions of dollars of expected losses. Even if assuming these
costs could be justified on public policy grounds, neither the Treasury nor the Federal
Reserve had the authority to commit public money in that way; in particular, the Federal
Reserve's loans must be sufficiently secured to provide reasonable assurance that the loan
will be fully repaid. Such collateral was not available in this case. Recognizing that Lehman's
potential failure posed risks to market functioning, the Federal Reserve sought to cushion the
effects by implementing a number of measures, including substantially broadening the
collateral accepted by the Fed's Primary Dealer Credit Facility (PDCF) and Term Securities
Lending Facility (TSLF) to ensure that the remaining primary dealers would have
uninterrupted access to funding.
In the case of AIG, the Federal Reserve and the Treasury judged that a disorderly failure of
AIG would have severely threatened global financial stability and the performance of the U.S.
economy. That judgment reflected our assessment of prevailing market conditions, AIG's
central role in a number of markets other firms use to manage risks, and the size and
composition of AIG's balance sheet. To avoid the default of AIG, the Federal Reserve was
able to provide emergency credit that was judged to be adequately secured by the assets of
the company. To protect U.S. taxpayers and to mitigate the possibility that lending to AIG
would encourage inappropriate risk-taking by financial firms in the future, the Federal
Reserve further ensured that the terms of the credit extended to AIG imposed significant
costs and constraints on the firm's owners, managers, and creditors.
AIG's difficulties and Lehman's failure, along with growing concerns about the U.S. housing
sector and economy, contributed to extraordinarily turbulent conditions in global financial
markets in recent weeks. Equity prices have fallen sharply, the cost of short-term credit,
where such credit has been available, has spiked, and liquidity has dried up in many
markets. One money market fund's losses forced it to "break the buck" - that is, the value of
its assets fell below par - an event that triggered extensive withdrawals from a number of
money market funds. Those funds responded to the surge in redemptions by attempting to
reduce their holdings of commercial paper and large certificates of deposit issued by banks.
Some firms that could not roll over maturing commercial paper drew on back-up lines of
credit with banks just as the banks were finding it even more difficult to raise cash in the
money markets. At the same time, a marked increase in the demand for safe assets - a flight
to quality and liquidity - resulted in a further drop in the value of mortgage-related assets and
sent the yield on Treasury bills down to a few hundredths of a percent.
Developments during the summer pressured not only nonbank financial firms, but also a
number of depository institutions, including Washington Mutual (WaMu) and Wachovia. In
recent weeks, these two institutions suffered deposit outflows and reduced access to
wholesale funding. The Office of Thrift Supervision, WaMu's regulator, closed that company
and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver; the FDIC
immediately sold the institution to JPMorgan Chase. In the case of Wachovia, to avoid
serious adverse effects on economic conditions and financial stability, the Secretary of the
Treasury, in consultation with the President and on the recommendation of the Federal
Reserve and FDIC, authorized the FDIC to use its funds to facilitate the sale of that
company's banking operations without loss to creditors. Both Citicorp and Wells Fargo have
offered to buy the company and negotiations are continuing. Most importantly, however, in
either case all depositors and creditors of Wachovia are fully protected, and depositors and
other customers will experience no interruption in banking services.
By potentially restricting future flows of credit to households and businesses, the
developments in financial markets pose a significant threat to economic growth. The
Treasury and the Fed have taken a range of actions to address the very tight funding
conditions that now prevail. For example, the Treasury implemented a temporary guarantee
program for balances held in money market mutual funds, helping to stem the outflows from
these funds and thus reducing their need to sell assets into already distressed markets. The
Federal Reserve has taken a number of steps, including putting in place a temporary lending
facility that provides financing for banks to purchase high-quality asset-backed commercial
paper from money market funds. The Fed has also significantly increased the quantity of
funds it auctions to banks and has accommodated heightened demands for funding from
banks and primary dealers; as of last Wednesday, our various lending facilities, including our
securities lending program, were providing more than $800 billion of liquidity to the financial
system. To address dollar funding pressures worldwide, we have significantly expanded
reciprocal currency arrangements (so-called swap agreements) with foreign central banks.
These agreements enable the foreign central banks to provide dollar funding to financial
institutions in their jurisdictions, which helps to improve the functioning of dollar funding
markets globally. In addition, this morning the Federal Reserve announced a new facility that
will help provide liquidity to term funding markets by purchasing three-month commercial
paper and asset-backed commercial paper directly from eligible issuers.
The expansion of Federal Reserve lending is helping financial firms cope with reduced
access to their usual sources of funding. Recently, however, our liquidity provision had
begun to run ahead of our ability to absorb excess reserves held by the banking system,
leading the effective funds rate, on many days, to fall below the target set by the Federal
Open Market Committee. This problem has largely been addressed by a provision of the
legislation the Congress passed last week, which gives the Federal Reserve the authority to
pay interest on balances that depository institutions hold in their accounts at the Federal
Reserve Banks. The Federal Reserve announced yesterday that it will pay interest on
required reserve balances at 10 basis points below the target federal funds rate, and pay
interest on excess reserves, initially at 75 basis points below the target. Paying interest on
reserves should allow us to better control the federal funds rate, as banks are unlikely to lend
overnight balances at a rate lower than they can receive from the Fed; thus, the payment of
interest on reserves should set a floor for the funds rate over the day. With this step, our
lending facilities may be more easily expanded as necessary. So long as financial conditions
warrant, we will continue to look for ways to reduce funding pressures in key markets.
Economic activity had shown signs of decelerating even before the recent upsurge in
financial-market tensions. As has been the case for some time, the housing market continues
to be a primary source of weakness in the real economy as well as in the financial markets.
However, the slowdown in economic activity has spread outside the housing sector. Private
payrolls have continued to contract, and the declines in employment, together with earlier
increases in food and energy prices, have eroded the purchasing power of households. This
sluggishness of real incomes, together with tighter credit and declining household wealth, is
now showing through more clearly to consumer spending. Indeed, since May, real consumer
outlays have contracted significantly. Meanwhile, in the business sector, worsening sales
prospects and a heightened sense of uncertainty have begun to weigh more heavily on
investment spending as well.
The intensification of financial turmoil and the further impairment of the functioning of credit
markets seem likely to increase the restraint on economic activity in the period ahead. Even
households with good credit histories are now facing difficulties obtaining mortgage loans or
home equity lines of credit. Banks are also reducing credit card limits, and denial rates on
automobile loan applications reportedly are rising. Businesses, too, are confronting
diminished access to credit. For example, disruptions in the commercial paper market and
tightening of bank lending standards have made it more difficult for businesses to obtain the
working capital they need to meet everyday operating expenses such as payrolls and
inventories.
All told, economic activity is likely to be subdued during the remainder of this year and into
next year. The heightened financial turmoil that we have experienced of late may well
lengthen the period of weak economic performance and further increase the risks to growth.
To support growth and reduce the downside risks, continued efforts to stabilize the financial
markets are essential. The Federal Reserve will continue to use the tools at its disposal to
improve market functioning and liquidity.
Inflation has been elevated, reflecting the steep increases in the prices of oil, other
commodities, and imports that occurred earlier this year, as well as some pass-through by
firms to consumers of their higher costs of production. However, more recently, the prices of
oil and other commodities, while remaining quite volatile, have fallen from their peaks, and
prices of imports show signs of decelerating. In addition, expected inflation, as measured by
consumer surveys and inflation-indexed Treasury securities, has held steady or eased.
These recent developments, together with economic activity that is likely to fall short of
potential for a time, should lead to rates of inflation more consistent with price stability. Still,
the inflation outlook remains highly uncertain, in part because of the extraordinary volatility of
commodity prices. We will need to continue to monitor price developments closely.
Overall, the combination of the incoming data and recent financial developments suggests
that the outlook for economic growth has worsened and that the downside risks to growth
have increased. At the same time, the outlook for inflation has improved somewhat, though it
remains uncertain. In light of these developments, the Federal Reserve will need to consider
whether the current stance of policy remains appropriate.
The intensification of the financial crisis in recent weeks made clear that a more powerful and
comprehensive approach involving the fiscal authorities was needed to solve these
problems. On that basis, the Secretary of the Treasury, with the support of the Federal
Reserve, went to the Congress to ask for a substantial program aimed at stabilizing our
financial markets. As you know, last week the Congress passed and the President signed the
Emergency Economic Stabilization Act. This legislation provides important new tools for
addressing the distress in financial markets and thus mitigating the risks to the economy. The
act adds broad, flexible authorities to buy troubled assets, to provide guarantees, and to
directly strengthen the balance sheets of individual institutions. Notably, the legislation
establishes a new Troubled Asset Relief Program, or TARP, under which the Treasury is
authorized to purchase as much as $700billion of troubled mortgages, mortgage-related
securities, and other financial instruments from financial firms that are regulated under U.S.
law and have significant operations in the United States. The act also raises the limit on
deposit insurance at banks and credit unions from $100,000 to $250,000 per account, a step
that should reinforce depositors' confidence in the security of their funds and thus help to
stabilize depository institutions. And, as I mentioned, the act provides the Federal Reserve
the authority to pay interest on reserves, which will allow us to better manage the federal
funds rate as we provide liquidity to the markets. We will begin exercising that authority this
week.
The TARP's purchases of illiquid assets from banks and other financial institutions will create
liquidity and promote price discovery in the markets for these assets. This in turn will reduce
investor uncertainty about the current value and prospects of financial institutions, enabling
banks and other institutions to raise capital and increasing the willingness of counterparties
to engage. More generally, increased liquidity and transparency in pricing will help to restore
confidence in our financial markets and promote more normal functioning. With time,
strengthening our financial institutions and markets will allow credit to begin flowing again,
supporting economic growth.
The interests of taxpayers are carefully protected under this program. First, the Congress
has required extensive controls and oversight to ensure that the allotted funds are used
appropriately and effectively. Second, the $700 billion allocated by the legislation is not an
authorization to spend but rather an authorization to purchase financial assets. The Treasury
will be a patient investor and will likely hold these assets for an appreciable period of time.
Eventually, however, some assets will mature, and the Treasury will choose to sell others to
private investors. Financially, in the long run, the taxpayer may come out either ahead or
behind in this process; in light of the many uncertainties, no assurances can be given. But
the ultimate cost of the program to the taxpayer will certainly be far less than $700 billion.
Third, and most important, restoring the normal flow of credit is essential for economic
recovery. If the TARP promotes financial stability, leading ultimately to stronger economic
growth and job creation, it will have proved a very good investment indeed, to everyone's
benefit.
To be sure, there are many challenges associated with the design and implementation of the
TARP, including determining which assets will be purchased and how prices will be
determined. The Treasury, with the advice and cooperation of the Federal Reserve, is
working to address these challenges as quickly as possible. It is unlikely that a single method
will be used for acquiring assets; inevitably, some experimentation will be necessary to
determine which approaches are most effective. Importantly, the legislation that created the
TARP does provide sufficient flexibility to allow for different approaches to solving the
problem - subject, of course, to the close oversight that will ensure that the program's funds
are used in ways that are in the interest of taxpayers.
These are momentous steps, but they are being taken to address a problem of historic
dimensions. In one respect, however, we are fortunate. We have learned from historical
experience with severe financial crises that if government intervention comes only at a point
at which many or most financial institutions are insolvent or nearly so, the costs of restoring
the system are greatly increased. This is not the situation we face today. The Congress and
the Administration chose to act at a moment of great stress, but one at which the great
majority of financial institutions have sufficient capital and liquidity to return to their critical
function of providing new credit for our economy. The steps being taken now to restore
confidence in our institutions and markets will go far to resolving the current dislocations in
the markets. I believe that the bold actions taken by the Congress, the Treasury, the Federal
Reserve, and other agencies, together with the natural recuperative powers of the financial
markets, will lay the groundwork for financial and economic recovery.