susan schmidt bies : economic outlook and developments in mortgage markets remarks by ms susan schmidt bies, member of the board of governors of the us federal reserve system, at the eller college of management distinguished speaker series, tucson, arizona, 18 january 2007. * * * to begin, i would like to thank dean portney and everyone at the eller college of management here at the university of arizona for the invitation to speak this evening. i know that this audience includes both experienced business leaders as well as students preparing to apply the knowledge they have learned in the classroom to the real world. accordingly, my remarks will first touch on the economic outlook. then, i will offer some thoughts on the challenges facing consumers as they navigate today ’ s changing mortgage loan market. economic outlook economic activity slowed in the middle part of last year. after rising at an annual rate of 3 - 1 / 4 percent over the previous two years, real gross domestic product ( gdp ) increased at an annual rate of 2. 6 percent in the second quarter of last year. real gdp growth in the second half of last year slowed after accounting for some measurement difficulties in the automotive sector. despite the recent slowing in output, however, resource utilization remains relatively high by historical standards and thus continues to be a potential source of upward pressure on inflation. in the aftermath of the 2001 recession, the federal open market committee ( fomc ) eased monetary policy substantially. however, the degree of easing in place in 2003 and 2004 was clearly unsustainable. since mid - 2004, the fomc has gradually moved monetary policy from an accommodative stance to a more neutral position. as a consequence, the elements now appear to be in place for some easing of resource utilization rates over the next year or so and a reduction in inflationary pressures. however, substantial uncertainty surrounds the near - term outlook. in determining the future path of interest rates, the fomc will be guided by the incoming data on both output and prices, so let ’ s begin by reviewing recent developments. economic activity the slowdown in the growth of real gdp since last spring largely reflects a cooling of the housing market : sales of both new and existing homes dropped sharply after their peak in the summer of 2005, the inventory of unsold homes has soared, and the number of single - family and multifamily housing starts has fallen nearly 30 percent since the beginning of last year. at the same time, homes are appre

cannot simply be done by observing market indicators. for example, we cannot easily use the public ratings of holding company debt. the ratings, after all, are achieved given the existence of the safety net. the ratings are biased, therefore, from the perspective of achieving our stated goal - - to impose prudential limits on banks as if there were no net. in addition, i am sure that there would be disagreement between market participants and regulators over what should be acceptable debt ratings. the solution may be for the regulators to use the analytical tools developed by the market participants themselves for risk and performance assessment. regulators already have begun to move in this direction. for example, beginning in january 1998, qualifying large multinational banks will be able to use their internal value - at - risk models to help set capital requirements for the market risk inherent in their trading activities. the federal reserve is also conducting a pilot test of the pre - commitment approach to capital for market risk. in this approach, banks can choose their own capital allocations, but would be sanctioned heavily if cumulative trading losses during a quarter were to exceed their chosen capital allocations. these new and innovative methods for treating the age - old problem of capital adequacy are likely to be followed by an unending, evolutionary flow of improvements in the prudential supervisory process. as the industry makes technological advances in risk measurement, these advances will become imbedded in the supervisory process. for example, the banking agencies have announced programs to place an increased emphasis on banks ’ internal risk measurement and management processes within the assessment of overall management quality - - that is, how well a bank employs modern technology to manage risk will be reflected in the “ m ” portion of the bank ’ s camel rating. in a similar vein, now that var models are being used to assess regulatory capital for market risk, it is easy to envision that, down the road, banks ’ internal credit risk models and associated internal capital allocations will also be used to help set regulatory capital requirements. regulation and supervision, like industry practices themselves, are continually evolving processes. as supervisors, our goal must be to stay abreast of best practices, incorporate these practices into our own procedures where appropriate, and do so in a way that allows banks to remain sufficiently flexible and competitive. in conducting prudential regulation we should always remember that the optimal number of bank failures is not zero. indeed, “ market - based ” performance means that some institutions, either through poor management choices,