frederic s mishkin : outlook and risks for the us economy remarks by mr frederic s mishkin, member of the board of governors of the us federal reserve system, to the money marketeers of new york university, new york, 10 september 2007. the original speech, which contains various links to the documents mentioned, can be found on the us federal reserve system ’ s website. * * * thank you for the invitation to be here this evening. 1 it is always a pleasure to be back in my hometown, and it is a particular pleasure to have a chance to talk again with the money marketeers. at the outset, i would like to acknowledge that tomorrow marks the sixth anniversary of the terrorist attacks on the world trade center, the pentagon, and united flight 93, which crashed in pennsylvania. the anniversary weighs on the minds of americans everywhere, and it weighs especially heavily on members of the new york financial community. that terrible day and its aftermath remind us that resilience is a defining characteristic not just of our economy and financial system but also of our country and our city. for as long as anyone who experienced it is alive, the memory of that awful day will not fade. in my remarks this evening, i will review the current economic situation and outlook and make some specific observations about recent developments in financial markets. i should note that the views i will express here are my own and not necessarily those of my colleagues on the federal open market committee ( fomc ). as everyone in this room knows, financial markets have been front and center in recent discussions about the economy. the fomc noted on august 17 that financial market conditions deteriorated last month and that the associated tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. indeed, at this point, housing demand seems likely to be crimped further by a marked reduction in the availability of mortgages, and consumer and business spending also could be damped as a consequence of the recent financial turmoil. in light of these events, we will need to make the best possible real - time judgments about the extent to which the recent developments in financial markets are likely to affect economic activity in the period ahead. that said, the economy ended the second quarter on a positive note. the commerce department ’ s bureau of economic analysis recently reported that the economy expanded at an annual rate of 4 percent in the second quarter, about 1 / 2 percentage point higher than the first estimate. of course, the jump in

fed was not expected to bring demand back into balance with supply, then inflation expectations would be much less likely to remain stable. this is why i believe that the federal reserve must remain vigilant on inflation but give appropriate attention to keeping demand from falling below supply as well. what does this all mean for the inflation outlook? at present, labor and product markets appear to be in reasonable balance. and i would expect the pressures on inflation that we have experienced from food and energy prices to abate. accordingly, with inflation expectations remaining stable around their current level, i see inflation as remaining in alignment with long - run expectations at around a 2 percent pace for the pce deflator. in addition, i believe that the risks to the inflation outlook have become more balanced, given the greater downside risks to real growth. let me shift gears and discuss developments in financial markets. as you know, the recent turmoil had its beginnings in the subprime mortgage market. 4 the development of the subprime market in the 1990s was an important financial innovation that enabled borrowers with higher credit risk to obtain mortgages that previously were unavailable to them. this expansion appears likely to have been a significant factor in raising the rate of homeownership from 64 percent, the level in 1994, to about 68 percent currently. in addition, subprime and other nonprime lending played an important role in the high volume of home sales in the mid - 2000s. indeed, data collected under the home mortgage disclosure act indicate that about 25 percent of the loans used to purchase single - family, owner - occupied homes in 2005 were high - priced loans, including primarily subprime and some near - prime mortgages. 5 however, as has been the case in previous instances of rapid financial innovations, adequate mechanisms to control excessive risk - taking may not have been in place during the subprime market ’ s greatest growth. one innovation, further development of securitized products, gave mortgage lenders greater access to the capital markets and spread risks more broadly. however, securitization also widened the separation of the originators from the ultimate holders of the loans – that is, those who bought securities backed by loans. in this setup, a classic principal - agent problem can arise if originators ( the agents ) do not have a sufficient incentive to shield the owners of the securities ( the principals ) from suffering higher - than - expected losses. against a backdrop of continued strong investor demand for high -