Chairman Bernanke on Food and Energy Prices

Letter to Editor of the Wall Street Journal that was never published.

From Mr Warren Mosler.

Dear Sir,

Chairman Bernanke has recently stated the following before Congress:

“…and futures quotes suggest that investors saw food and energy prices coming off their recent peaks next year.”

– Testimony, Chairman Ben S. Bernanke,
“The Economic Outlook” Before the Joint Economic Committee, U.S. Congress, November 8, 2007

It appears from this and previous similar statements that the Chairman is using the “futures market” prices of crude oil as a forecast of what prices are likely to be in the future. This is incorrect.

When a ‘non-perishable’ commodity like oil is in short supply, this condition is expressed by the spot price trading higher than prices for future delivery. When, instead, inventories are plentiful, prices for delivery in the future are higher than spot prices.

Clearly a commodity in short supply is not necessarily less apt to appreciate than a commodity where inventories are plentiful. Yet that is exactly how the Fed model appears to be programmed: the current backwardation in crude oil is viewed as indicative of lower prices over
time, rather than indicative of a product in very short supply, where spot prices can at least as easily go up as down.

Yours faithfully,

Warren Mosler
Senior Associate Fellow,
Cambridge Centre for Economic and Public Policy,
University of Cambridge,
Chairman,
Valance Co. 5000 Estate Southgate
Christiansted, St. Croix, USVI 00820
Office phone: 340 692 7710
E-Mail: warren.mosler@gmail.com

Professor James K. Galbraith
Lloyd M. Bentsen, Jr. Chair in Government/Business Relations
LBJ School of Public Affairs
The University of Texas at Austin
Austin TX 78713-8925

Posted in Fed

Review of Kroszner Speech

Governor Randall S. Kroszner
At the Philadelphia Fed Policy Forum, Philadelphia, Pennsylvania
November 30, 2007

Innovation, Information, and Regulation in Financial Markets

Good afternoon. I am pleased to participate in the excellent annual Philadelphia Federal Reserve Policy Forum to discuss this year’s timely topic of innovations in financial markets. Innovations in financial markets have created a wide range of investment opportunities that allow capital to be allocated to its most productive uses

This is highly questionable but assumed by the fed to be true. The allocation is necessarily a function of the market forces operating within the legislated institutional structure.

and risks to be dispersed across a wide range of market participants. Yet, as we are now seeing, innovation can also create challenges if market participants face difficulties in valuing a new instrument because they realize that they do not have the information they need or if they are uncertain about the information they do have. In such situations, price discovery and liquidity in the market for those innovative products can become impaired.

Yes, that has been the fed’s issue for the last three months. What they call ‘market functioning’ as related to the real economy.

In my remarks today, I would like to explore the role of information in the development of new financial products and then draw some lessons about risk management and regulation. In particular, I will examine the role that investment in information gathering, processing, and evaluating plays in supporting the price discovery process and how such investment can lead toward a tendency to greater standardization as markets for innovative financial products mature. Examples from both history and current experience will help to illustrate this tendency with respect to loan work-outs and restructurings. I will then conclude by considering how a regulatory approach that encourages transparency and sound risk management, such as Basel II, can be valuable in fostering a robust environment for the introduction of innovative financial products.

Experimentation and Learning in New Instrument Development

Typically, when a new product is being developed, there is an initial experimentation phase in which market participants learn a great deal about the product’s performance and risk characteristics. This phase involves gathering and processing information and modeling the performance of the product in various scenarios and under different market conditions. It may then take time for market participants to understand what, exactly, they need to know to value a product. During the early phases, a fair amount of due diligence is appropriate, given the greater uncertainty associated with innovative products. The investment in gathering, processing, and evaluating information then, as I will discuss, often leads to greater standardization of products and contract terms, which can enhance liquidity of products as their markets mature.

In the initial experimentation phase, the terms and characteristics of a new product are adjusted in response to market acceptance–or lack thereof. During this period, market participants are seeking and providing information so that they can properly value the product, judge its potential for risk and return, assess its market acceptance and liquidity, and determine the extent to which the risks of the product can be hedged or mitigated.

When a product’s track record is not well established, there should be a strong market demand for information in order to facilitate price discovery. Price discovery is the process by which buyers’ and sellers’ preferences, as well as any other available market information, result in the “discovery” of a price that will balance supply and demand and provide signals to market participants about how most efficiently to allocate resources. This market-determined price will, of course, be subject to change as new information becomes available, as preferences evolve, as expectations are revised, and as costs of production change.

In order for this process to work most effectively, market participants must utilize information relevant to value that product. Of course, searching out and using relevant sources of information–as well as determining what information is relevant–has its own costs. To underscore the last point, with new instruments, it may not even be clear exactly what information is needed for price discovery–that is, some market participants may not know what they do not know and they may therefore terminate the information-gathering stage prematurely, unwittingly bearing the risks and costs of incomplete information.

He leaves out the fact that fed member banks are specifically designated to be outside this process. They lend based on internal credit analysis based on standards set by federal regulators. The loans are reviewed continuously regarding the borrower’s ability to make timely payment of principal and interest, both short term and long term. If these are not deemed adequate, loans must be ‘qualified’ and banks must add to their loss reserve. for all practical purposes, banks must have government insured liabilities which exert no ‘market discipline’ on assets, and therefore government regulation is required to fill that function. This system operates independently of market pricing of these bank assets. Market discipline comes via shareholders in first loss position with regulators determining appropriate capital ratios. Over the years, this has proved a much more stable platform for credit expansion.

The current problem areas are the ‘market price’ based activity that is outside of the above standard bank model. One result has been a short decline in commercial paper, for example, and a corresponding increase in bank lending, as the underlying lending has been replaced by traditional, nonmarket, bank lending, and credit analysis.

Price Discovery

Due diligence is an important part of the price discovery process. The due-diligence process allows market participants to “trust but verify”market-provided information through a range of activities, from assessing risks and exposures through stress-testing to assessing the enforceability of the contracts that define the legal relationship among originators, sponsors, investors, and guarantors. The due diligence is complemented by risk-management structures that allow participants to interpret, understand, and act appropriately in response to the information in the market.

Recently we have seen how a lack of information and inadequate due diligence and risk management have created problems in the market for certain structured finance products. Let me focus a moment on structured investment vehicles, or SIVs. SIVs have been created with a variety of terms and characteristics–for example, different underlying assets, different levels of liquidity support or guarantees, and various triggers that require the forced sale of assets or liquidation of the structure. Although SIVs or similar vehicles have existed for many years, many recent SIV structures involved a much higher level of complexity of the underlying credit risks, legal structures, and operations. This complexity–and the lack of information about where the underlying credit, legal, and operational risks resided–made these products more difficult and costly to value than many investors originally thought. Investors suddenly realized that they were much less informed than they assumed and, not surprisingly, they pulled back from the market.

The better way to state this is that risk was repriced. The spreads got wide enough for banks to underwrite and ‘absorb’ the loan demand. That’s how those markets function under current institutional structure.

We have seen similar problems in the subprime residential mortgage-backed securities market and the related derivatives markets. The lack of long historical data on the performance of these instruments, and their correlations with other assets and instruments, made it difficult to assess their overall risk-return profile, especially in times of stress. Moreover, in the subprime residential mortgage-backed securities market, many market participants were willing to proceed without conducting robust due diligence and without establishing appropriate risk-management structures and processes.

This means they priced the risk low enough to ‘win’ the right to invest. They changed their minds, and at that point owned over priced securities, to be sold only at lower prices/higher yields.

Same below..

They did not follow “trust but verify,” that is, they instead accepted the investment-grade ratings of these securities as substitutes for their own risk analysis. Ratings keyed to expected default or credit loss do not adequately capture the full range or magnitude of risks to which a product may be subject, including–as we have seen most dramatically–market liquidity risks. In addition, some originators may not have demanded sufficient information about the purchased assets underlying these structures and therefore may not have fully appreciated the credit risk of the assets and the consequential risk that the structures would come back on balance sheet when the assets defaulted.

When the problems in the subprime mortgage market began to emerge and delinquencies exceeded rating agency estimates and the defaults predicted by limited historical data, we had moved beyond our past experience with these instruments. Information was not readily available about the extent to which the economic context had changed, or even whether underlying loans would or could be modified to prevent default. When ratings were downgraded, investors lost confidence in the quality of the ratings and hence the quality of the information they had about subprime investments. Lack of information, a disrupted price-discovery process, and a stressed environment led to a reassessment of risk, not only in the subprime market but also in the residential mortgage market across the board.

Of course, this is not the first time that participants in a market for an innovative product have suffered losses. In the early 1990s, participants in the collateralized mortgage obligation (CMO) market and the markets for structured notes and certain types of interest rate derivatives did not have adequate information about the potential volatility and prepayment risk involved. Consequently, market participants did not appropriately model these risks and suffered significant losses when market interest rates rose sharply in the mid-1990s. As in the case of the residential mortgage-backed securities market today, the general market reaction was a flight away from these instruments. However, over time, the market was restored as market participants came to better understand the risks and as standardized methods were developed to measure the risks and model the value of these instruments under alternative scenarios. Increased information and standardized pricing conventions, such as the use of option-adjusted spreads, moved these instruments from the experimentation and learning phase to the phase of broad market acceptance.

When market participants realize that they do not have the information necessary for proper valuation of risks, the price-discovery process can be disrupted, and market liquidity can become impaired. A significant investment in information gathering, processing, and evaluation may be necessary to revive the price discovery process. This revival is likely to take time and the market may not look the same when it re-emerges.

We’ve had three months since the ‘crisis’ began. We made it through so far. Risk has been repriced. Spreads are wider. Less is trading which is not necessarily a ‘bad thing’ at the macro level. Banks are lending aggressively directly to borrowers in good standing.

Let me describe in a bit more detail the ways in which these investments will take place and hence why recovery of price discovery may be a gradual process. First, market participants will likely need to collect more-detailed data in a more systematic manner in order to better understand the nature and risks of the instruments and their underlying assets. Second, investments in enhanced systems to warehouse and model data related to these instruments will facilitate a better understanding of their risks, particularly under stress conditions. Third, investors need to ensure that they have the so-called human capital expertise–that is, the people–to underst and, interpret, and act appropriately on the results of the modeling and analysis of the information gathered. The pay-off from these investments will be a greater understanding of risks and greater ability to value the instruments.

Yes, and that’s why it took several weeks for the banking system to ‘absorb’ market based lending. That process is now well underway.

The Development of Greater Standardization in a Market

Another consequence of information investments is a tendency towards greater standardization of many of the aspects of an instrument, which can help to increase transparency and reduce complexity. As was demonstrated in the CMO market, as the market gains information about a product and develops a level of confidence in that information, the product tends to become increasingly standardized. Standardization in the terms and in the contractual rights and obligations of purchasers and sellers of the product reduces the need for market participants to engage in extensive efforts to obtain information and reduces the need to verify the information that is provided in the market through due diligence. Reduced information costs in turn lower transaction costs, thereby facilitating price discovery and enhancing market liquidity. Also, standardization can reduce legal risks because litigation over contract terms can result in case law that applies to similar situations, thus reducing uncertainty.

The benefits of the development of standardization for enhancing the liquidity of financial markets have a long history. One particularly clear example dates back to the development of exchange-traded commodities futures contracts in the mid-1800s. The standardization of the futures markets improved the flow of information to market participants, reducing transaction costs and fostering the emergence of liquid markets.

Fostered an army of traders who could have been out curing cancer or something else more useful. Little or none of the ‘financial innovation’ has led to more efficient allocations of real resources, but instead has absorbed the brightest and best in to the world of ‘rearranging of financial assets’ encouraged under current institutional structure, including tax law and tax advantage savings programs under the misguided notion that ‘savings is needed to provide funds for investment’ as every economist is (or at one time was) well aware.

In the early days of the Chicago Board of Trade, in the mid-1850s, standardization took the form of creating “grades” or quality categories for commodities such as wheat, allowing for the fungibility of grains stored in elevators and warehouses, and breaking the link between ownership rights and specific lots of a physical commodity.Traders no longer needed to verify that a certain quantity of grain was of a sufficiently high grade because the exchange established a system of internal controls in the form of grain inspectors and a self-regulatory system to arbitrate disputes. The grain inspectors charged a set fee to certify the quality of the grain for any receipt traded at the board, a system with parallels to the mechanisms employed today by the rating agencies.1

In effect, standardization and related controls reduced traders’ information requirements and, thus, their transaction costs. In 1865,the Chicago Board of Trade standardized the delivery dates for the contracts, thus fostering the emergence of liquid markets in which traders could readily hedge the risk of price changes in the commodities and contracts. A final step toward standardization came years later with the adoption of the clearinghouse for the exchange as the common counter party to all of the contracts traded on the exchange. With a central counterparty, the costs and uncertainties of failures and restructurings were significantly reduced, thereby reducing work-out costs and enhancing liquidity of the contracts traded on the exchange.2

As above, for what further purpose??? He is treating ‘market functioning’ as an end rather than a means with a proper cost/benefit analysis.

The benefits of standardization can be realized not only on organized exchanges but also in over-the-counter markets. In more recent times,for example, the creation of the International Swaps and Derivatives Association (ISDA) master agreement for over-the-counter swaps and derivatives contracts has brought about the benefits of standardization while also allowing for product flexibility and customization. The ISDA master agreement provides standard definitions and a general outline for the contract but allows latitude in customizing terms. The master agreement also sets forth a template for workout procedures if a counterparty defaults, allowing parties to the agreement to adjust their risk-management strategies in light of the agreed-upon work-out process. This standardization reduces uncertainty about the instruments, which lowers transaction costs and facilitates price discovery and market liquidity.

Yes the most efficient structures would be a futures contract which the dealers have successfully blocked over the years.

The examples from the long- and more recent- past may hold some valuable lessons for how improvements in standardization could help to address some of the challenges in the subprime market. Uncertainty about the work-out process and the options that are available, for example, could be contributing to the difficulties in reviving price discovery and liquidity in the market for subprime residential mortgage-backed securities.

How about just let the banks underwrite the mtgs to regulatory standards???

Part of the valuation challenge is gauging the extent of the difficulties that borrowers will have in making payments and being able to stay in their homes given the reduction in house price appreciation–or actual declines in some areas–and the large number of interest rate resets coming on many adjustable-rate mortgages. From now until the end of next year, monthly payments for an average of roughly 450,000 subprime mortgages per quarter are scheduled to undergo their first interest rate reset. In addition, tightening credit conditions as reported in the Federal Reserve’s Senior Loan Officer Opinion Surveys on Bank Lending Practices suggest that refinancing may become more difficult.

Lenders and servicers generally would want to work with borrowers to avoid foreclosure, which, according to industry estimates, can lead to a loss of as much as 40 percent to 50 percent of the unpaid mortgage balance. Loss mitigation techniques that preserve homeownership are typically less costly than foreclosure, particularly when applied before default. Borrowers who have been current in their payments but could default after reset may be able to work with their lender or servicer to adjust their payments or otherwise change their loans to make them more manageable.

The govt has to either ban the origination of adjustable rate mtgs but not legally enforcing any such contracts or face the consequences of allowing them, which we are seeing. Either you believe in that much personal freedom and risk taking or you don’t.

It is imperative that we work together as a financial services community to look for ways to help borrowers address their mortgage challenges, particularly for those who may have fewer alternatives, such as lower-income families. The Federal Reserve and other regulators have been active in encouraging lenders and servicers to take a proactive approach to work with borrowers who may be at risk of losing their homes. For example, the agencies have issued statements underscoring that prudent workout arrangements that are consistentwith safe and sound lending practices are generally in the long-termbest interest of both the investor and the borrower and have had numerous meetings with interested parties to foster the development and implementation of work-out arrangements.

Given the substantial number of resets from now through the end of 2008, I believe it would behoove the industry to go further than it has to join together and explore collaborative, creative efforts to develop prudent loan modification programs and other assistance to help large groups of borrowers systematically. I am not suggesting a one-size-fits-all approach, but a bottom-up approach designed to appropriately balance the needs of all parties. Getting to borrowers who have been making payments but are at risk of falling behind before they actually do become delinquent, for example, can help to preserve work-out and refinancing options.

Some industry participants and consumer groups have begun to work collaboratively to develop loan-modification templates, standards, and principles that can help to streamline the work-out and modification process. This can reduce transaction costs and potentially provide timely relief to a wider range of borrowers. A systematic approach to loan modifications would likely reduce some of the uncertainties in the market for such subprime mortgage-backed securities, helping to restore price-discovery and liquidity. This would help to ease the tightening of credit conditions in the market.

I am privileged to serve as a board member of Neighbor Works America, anational nonprofit that partners with the HOPE NOW Alliance. This alliance is developing ways to facilitate the flow of information between servicers and distressed borrowers and to work toward clarification of loan-modification procedures. Increased standardization and certainty could also benefit investors in the mortgage market by improving information flows and the price-discovery process, thereby improving market liquidity while at the same time helping to avoid foreclosures and promoting sustainable homeownership.

A Regulatory Environment That Encourages Sound Risk Management and Transparency

Recent market events have underscored the need for better market information about new products, robust due diligence to verify that information, and risk-management strategies to utilize the information in management decision making. The supervisory agencies and the industry both are addressing the need for improved risk management in light of the market disruptions The newly adopted Basel II capital framework for large internationally-active banking organizations, for example, is an important advance that encourages the types of investment in information I discussed earlier. The Basel II framework is comprised of three pillars. Pillar 1 requires information gathering and robust modeling techniques to better take into account the risks of different types of instruments and securities than under the traditional Basel I framework. It also provides incentives for more robust risk management in connection with certain higher-risk activities, such as securitization and other off-balance-sheet activities. Pillar 2 emphasizes the further stress testing and analysis of the data in conjunction with an ongoing evaluation of the institution’s capital adequacy in light of its risks through the internal capital adequacy assessment process. Pillar 3 reflects the need for better information through investments in data gathering and analysis that are reflected in enhanced public disclosures and regulatory reporting. More-comprehensive and more-transparent information allows investors to better understand the banking organization’s risk profile and thus reduces transaction costs and facilitates price discovery and market liquidity. The three pillars of Basel II promote precisely the three types of investment in information discussed earlier that facilitate the price discovery process.

In addition to supervisory initiatives, industry leaders’ efforts to influence the adoption of sound practices and codes of conduct can efficiently and effectively facilitate market-correcting behaviors. To this end, the industry is actively engaged in efforts to improve sound practices for risk management through improved stress-testing practices to cover contingent exposures, marketwide events, and potential contagion and enhanced due diligence and modeling for new products. As they look into the causes of the recent market disruptions and determine the appropriate response, both supervisory and industry groups are carefully analyzing the weaknesses in risk management and the lack of transparency in complex structures–and the implications of that lack of transparency for proper valuations.

Conclusion

The recent market disruptions have dramatically underscored the importance of gathering and analyzing information about innovative products. When the price-discovery process for a product is disrupted, both investors and sellers need to engage in a period of information gathering, processing, and analysis in order to re-establish a market price. This can be a gradual process and one that results in fundamental changes to the market for the product. Efforts underway by both supervisors and the industry should encourage improvements in risk analysis and management and, thus, price discovery. We are hopeful that our efforts to increase the standardization of loan-modification options and processes for subprime loans will help to provide more information to lenders, investors, homeowners, and communities faced with potential mortgage loan defaults while at the same time helping to provide more timely relief for borrowers in distress.


Footnotes
1. See Randall S. Kroszner (1999), “Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearing Houses and Recent Over-the-Counter Innovations,” Journal of Money,Credit, and Banking, vol. 31 (August), p. 600. Return to text
2. See Kroszner, “Can the Financial Markets Privately Regulate Risk?”, p. 601.


Re: fed action to alleaviate turn

(interoffice email)

> The Fed through it’s SOMA account injected reserves in the
> market through a repo operation that included only AGCY
> MBS. 8bb for 43 days (1/10/08).
>
> This should help to keep the spread between GC Tsy and
> AGCY MBS GC from widening much further. MBS recently
> traded as high as 6% over the turn while treasuries are trading
> in the low3’s..

Thanks, Pat – should make a difference. Also, they did trade, which is pretty much all the fed wants – risk getting repriced and markets functioning.


Re: U.S. $ and oil prices; the T-bill and the fed target rate

(email from Tom @ Laffer Investments)

> Looking at this chart of the 91-day T-bill…don’t think
> the Fed’s not going to cut rates on December 11th. We
> expect .50 bps and more cuts early next year…unless
> something changes.

The low t-bill rate is due to money funds switching asset choices away from any perception of risk, and moving the indifference levels between bills and fed funds, libor, etc. It’s part of what is being called ‘repricing of risk’ and has nothing to do with where the fed funds rate ‘ought to be’.

> Arthur and I were discussing Abu Dhabi’s investment in
> Citigroup. As you know, Arthur has been saying that
> the dollar can only fall so far until investors step
> in to buy U.S. denominated assets. When that starts
> in earnest, he says, the dollar will find a bottom.
> (See Laffer Associate’s ‘Whither the Dollar’). Abu
> Dhabi’s massive investment may signify that point. We
> would not be surprised to see a floor forming in the
> U.S. dollar as a result of factors such as the
> Citigroup investment.

Agreed! PPP is a powerful force, but often takes quite a while to assert itself.

Additionally, ‘fundamentals’ in favor to the $US also include the fact that the US budget deficit as a % of GDP is at a very low level, which tightens the ‘new’ supply of $US denominated net financial assets available.

Forces working against the $US recently recently are portfolio shifts due to concern over fed policy that has the appearance of ‘inflate your way our of debt’ and ‘beggar thy neighbor’ demand stealing ‘competitive devaluations/exports’.

Once the flood of portfolio shifts subsides, I agree the $US looks ok.

> Which leads us to oil prices. As you know, we look
> for the substitution effect in the supply of and
> demand for oil to create a ceiling on oil prices.
> That substitution effect is clearly underway. The
> wild-card has been the U.S. dollar. A weakening
> dollar has postponed the fall in oil prices, as you
> know.

The Saudis are acting as swing producer – posting price and letting quantity pumped adjust, thereby setting price at whatever level they want. So, the thing to watch is Saudi production. If it rises, that’s bullish for oil as it indicates more demand at the current prices. If Saudi production falls, it means net supply is increasing and the Saudis are able to sell less at current prices. They will hold price until the amount they are selling falls below 7 million BPS is my best guess.

Also, to compound matters, the Russians are doing the same thing; so, we have two swing producers, and the price goes to the higher of where the two post prices, as at the margin we need all of their current production of the day.

> We would not be surprised to see other investors step
> in to buy U.S. assets on the cheap much as Japan did
> in the early 90’s. You may remember the effect
> Japan’s buying had on the U.S. dollar then.

Yes, the $US shortage caused by tight US fiscal policy will turn the boat when the international portfolios run out of amo.

> A strengthening dollar and a slowing global economy
> could knock much of the froth out of oil prices.

Only if the Saudis/Russians decide to accept lower prices. Don’t underestimate them!!!

> Regarding OPEC: don’t think they aren’t aware of the
> fact that the U.S. economy is slowing.
>
> Maybe because so far it isn’t. Gasoline demand is still going up, though at a slower rate.
> Don’t think the heightened level of fear regarding a
> U.S. recession isn’t effecting their discourse heading
> into their December 5th meeting. We expect them to
> pump more oil. It doesn’t behoove them to be an
> accomplice in the murder of the U.S. economy.

They already pump all that’s demanded at their posted prices. You’re missing that dynamic in your analysis, and Art agrees with me.


♥

Q&A with Kohn

Kathleen Stephansen from Credit Suisse:
Just thank you very much for this very interesting speech. Just a question: You alluded to the discount rate and the stigma that it still carries. Would you think that if there was no spread between the discount rate and the Fed funds rate, whether that stigma would disappear?

Kohn from the fed:
I think if there were no spread, the economic incentives might overcome the stigma. I’m not sure that the stigma would entirely disappear.

Agreed.

But I think part of what we’re seeing — if I can sort of reframe your question — about the lack of use of the discount window is partly economic and partly non-economic or partly about the 50 basis points, but partly about the stigma. And obviously, if we take the 50 basis points away and you can simply borrow at the federal funds rate, in effect I think the funding market would come all into the Federal Reserve. I mean, everyone would be borrowing a lot, including people who don’t — it’s a very — it would be a very difficult thing to do.

Perhaps true, but not a ‘bad’ thing where the fed would be ‘broker of last resort’.

The question is, what is the further purpose of not doing it that way? What is gained by banks settling clearing residuals with each other rather than with the fed?

Net lending from the fed would be unchanged, as banks strive to minimize reserve balances in either case.

Real resources would be saved, as banks would not need to spend the time and effort trying to trade with each other.

The NY fed would have full control over the fed funds rate as it could keep the system modestly ‘net borrowed’ with open market operations as it did pre 2003.

The only possible value of the current arrangement would be if the employed market forces as a discipline on bank funding. But it doesn’t, so there is no advantage for the current set up that I can see.

There are people who don’t borrow at the federal funds rate, right — smaller, medium-sized banks. And if they saw this window, they would come in and borrow — basically, we would be giving them funds at a subsidized rate that people don’t ordinarily have access at the funds rate.

Point? Why should money center banks have access to cheaper funds than regional member banks? All carry the same deposit insurance, and smaller banks have higher percentages of insured deposits.

Doesn’t the fed desire the fed funds rate to be the universal cost of bank funds? If not, that can be addressed in other ways.

And we would be creating, I think, problems for the open markets, because they would have to anticipate how many reserves are going to be supplied through the discount window, which would be very hard to anticipate, and then drain those through open-market operations.

No, the NY fed would instead find its job far easier. Just keep banks net borrowed in any quantity. And if they over do it with excessive liquidity drains, it will only show up as increased window borrowings, not as a deviation of the fed funds rate from the target rate.

That’s not to say that circumstances might not dictate at some point that we do something more with that penalty. I don’t want to take that off the table. I think it’s fair to say — as I kind of hinted at in my little section on liquidity — that we’re looking at lots of different options about how to supply liquidity to the market. But I think we need to recognize that the one you came up with has some costs and some difficulties associated with it.

I see a reduction in costs and a reduction in the difficulties surrounding current policy.


Review of Bernanke Speech

(prefaced by interoffice email)

> Key line is the Committee will have to judge whether the outlook
> for the economy or the balance of risks has shifted materially. This
> opens the door for changing the balance of risk at the next FOMC
> meeting (Towards weaker gwth in light of expressed concerns on
> markets). This could mean a cut with a changed bias, or no cut
> and a changed bias (less likely).

Yes, agreed, and the inflation risk has elevated as well.

If they are thinking of a discount rate cut to the fed funds rate they may do it before the meeting to see if it alters the fed funds/libor spread. If they do that and spreads do come in over year end (the current cause of higher short term non tsy rates as mentioned in some of the Fed speeches) that will tilt the balance of risks aways from ‘market functioning’ risks.

Worth looking at the entire speech..

Chairman Ben S. Bernanke
National and regional economic overview
At the presentation of the Citizen of the Carolinas Award, Charlotte
Chamber of Commerce, Charlotte, North Carolina
November 29, 2007

Good evening. I thank the Charlotte Chamber of Commerce for bestowing on me this year’s Citizen of the Carolinas Award. I deeply appreciate the honor, and I am grateful for the opportunity it gives me to speak to you this evening. I am also delighted to be here in Charlotte. My wife Anna and I are looking forward to visiting family and friends during our time here in the Queen City.

The focus of my brief remarks this evening will be the Charlotte region and how the area and the economy have changed since I regularly visited my grandparents here some four-and-a-half decades ago. First, though, I would like to share a few thoughts on the U.S. economy and the considerations that we at the Federal Reserve will be weighing as we prepare for our policy meeting on December 11, less than two weeks from now.

The Federal Open Market Committee (FOMC), the monetary policy making arm of the Federal Reserve System, last met on October 30-31. At that meeting, the Committee cut its target for the federal funds rate, the key policy interest rate, by 25 basis points (1/4 of a percentage point), following a cut of 50 basis points in September. Economic growth in the period leading up to the October meeting had proven quite strong, as confirmed by this morning’s figures on third-quarter gross domestic product (GDP). At its meeting, however, Committee members took the view that tightening credit conditions–the product of ongoing stresses in financial markets–and some intensification of the correction in the housing sector were likely to restrain economic activity going forward.

Potential ‘market functioning’ risk.

Specifically, growth appeared likely to slow significantly in the fourth quarter from its rapid third-quarter rate and to remain sluggish in early 2008. The Committee expected that economic growth would thereafter gradually return to a pace approaching its long-run trend as the drag from housing subsided and financial conditions improved. Inflation was seen as edging down next year, approaching rates consistent with price stability;

Implying it’s too high now.

however, the Committee remained concerned about the possible effects of higher energy costs and the lower foreign exchange value of the dollar, especially the risk that they might lead to an increase in the public’s long-term inflation expectations.

Yes, which led to a dissenting vote and six regional banks not wanting a cut.

How has the economic picture changed in the month since that meeting? As is often the case, the incoming economic data have been mixed.

This is the sum of data – not clearly worse and not clearly worse than forecast. My guess in Q4 is their Q4 forecast has been revised up, and the continual upward revisions of Q3 and now Q4 have to be influencing their view of Q1 forecasts and beyond as well.

In the market for residential real estate, indicators of construction and home sales have continued to be weak. In contrast, the labor market remained solid in October, with some 130,000 new jobs added to private-sector payrolls and the unemployment rate remaining at 4.7 percent. Claims for unemployment insurance have drifted up a bit in recent weeks, although, on average, they have remained at a level consistent with moderate expansion in employment. We will, of course, have the labor market report for November next week, and in the coming days we will continue to draw on anecdotal reports, surveys, and other sources of information about employment and wages. Continued good performance by the labor market is important for maintaining the economic expansion, as growth in earnings helps to underpin household spending.

Strong emphasis on employment data. It has probably been the most reliable indicator over the last six months. No one could ‘understand’ how employment remained high until after late numbers on exports came in, for example.

With respect to household spending, the data received over the past month have been on the soft side. The Committee will have considerable additional information on consumer purchases and sentiment to digest before its next meeting. I expect household income and spending to continue to grow, but the combination of higher gas prices, the weak housing market, tighter credit conditions, and declines in stock prices seem likely to create some headwinds for the consumer in the months ahead.

And ‘on the soft side’ is no reason to cut – especially with exports growing rapidly and supporting demand at high levels.

Core inflation–that is, inflation excluding the relatively more volatile prices of food and energy–has remained moderate.

But not moderated further.

However, the price of crude oil has continued its rise over the past month, a rise that will be reflected in gasoline and heating oil prices and, of course, in the overall inflation rate in the near term. Moreover, increases in food prices and in the prices of some imported goods have the potential to put additional pressures on inflation and inflation expectations.

He is stating directly the inflation risk has increased since October 31.

The effectiveness of monetary policy depends critically on maintaining the public’s confidence that inflation will be well controlled. We are accordingly monitoring inflation developments closely.

They believe they must have credibility to keep inflation expectations anchored.

The incoming data on economic activity and prices

Both – which includes CPI forecasts available before the December 11 meeting.

will help to shape the Committee’s outlook for the economy; however, the outlook has also been importantly affected over the past month by renewed turbulence in financial markets, which has partially reversed the improvement that occurred in September and October.

Partially. Being in the middle with active trading is perfectly acceptable. The concern is spreads will widen further/rapidly to the point trading ceases and real world lending ceases as a consequence, though the ‘channel’ for this is uncertain, and mainstream economic theory probably would say it’s a natural adjustment process that should be left alone for optimal long term outcomes.

Comments welcome on this point, thanks!

Investors have focused on continued credit losses and write-downs across a number of financial institutions, prompted in many cases by credit-rating agencies’ downgrades of securities backed by residential mortgages. The fresh wave of investor concern has contributed in recent weeks to a decline in equity values, a widening of risk spreads for many credit products (not only those related to housing), and increased short-term funding pressures.

All a repricing of risk.

These developments have resulted in a further tightening in financial conditions, which has the potential to impose additional restraint on activity in housing markets and in other credit-sensitive sectors.

But perhaps to where it ‘should be’ as the fed did not like it when risk was priced at zero. What they are watching closely is ‘market functioning’ and the risk of systemic failure.

Needless to say, the Federal Reserve is following the evolution of financial conditions carefully, with particular attention to the question of how strains in financial markets might affect the broader economy.

As above.

In sum, as I have indicated, we will be receiving a good deal of relevant information in the coming days. In making its policy decision, the Committee will have to judge whether the outlook for the economy or the balance of risks has shifted materially.

Implying so far it has not.

In doing so, we will take full account of the implications for the outlook of both the incoming economic data and the ongoing developments in the financial markets.Economic forecasting is always difficult, but the current stresses in financial markets make the uncertainty surrounding the outlook even greater than usual. We at the Federal Reserve will have to remain exceptionally alert and flexible as we continue to assess how best to promote sustainable economic growth and price stability in the United States.

Perhaps a reference to Kohn’s discount rate discussion where he discusses addressing liquidity vs. addressing the macro economy, a discussion which has gotten into the ‘stigma’ aspect of the discount rate that he felt was an obstacle to liquidity.

References
Employment Security Commission of North Carolina (2007). “Employment
and Wages by Industry, 1990 to Most Recent,”
www.ncesc.com/lmi/industry/industrymain.asp.

Hills, Thomas D. (2007). “The Rise of Southern Banking and the
Disparities among the States following the Southeastern Regional
Banking Compact (225 KB PDF),” Balance Sheet, vol. 11, pp. 57-104,
http://studentorgs.law.unc.edu/ncbank/balancesheet.

North Carolina Community College System (2006). “Get the Facts,”
press release, July 3,
www.ncccs.cc.nc.us/News_Releases/GetTheFacts.htm.

U.S. Census Bureau (2006). “2005 American Community Survey,”
www.census.gov/acs.


Review of Evans Speech

November 27, 2007

Financial Disruptions and the Role of Monetary Policy*

Skipped the first part. It’s very good history and analysis.

With regard to shocks to the financial system, our concern is about the ability of financial markets to carry out their core functions of efficiently allocating capital to its most productive uses and allocating risk to those market participants most willing to bear that risk. Well-functioning financial markets perform these tasks by discovering the valuations consistent with investors’ thinking about the fundamental risks and returns to various assets. A widespread shortfall in liquidity could cause assets to trade at prices that do not reflect their fundamental values,

The fed’s concern is very well stated here. It’s about availability of credit:

impairing the ability of the market mechanism to efficiently allocate capital and risk. And reduced availability of credit could reduce both business investment and the purchases of consumer durables and housing by creditworthy households.

We clearly must be vigilant about these risks to economic growth. However, overly accommodative liquidity provision could endanger price stability, which is the second component of the dual mandate. After all, inflation is a monetary phenomenon. Indeed, one of the many reasons for the Fed’s commitment to low and stable inflation is that inflation itself can destabilize financial markets. For example, in the late 1970s and early 1980s, high and variable inflation contributed to large fluctuations in both nominal and real interest rates.

The above articulates that the inflation risk is also a risk to markets, as well as growth and employment.

The Fed has kept these various risks to growth and inflation in mind when responding to the financial turmoil this year. Importantly, we have taken a number of monetary policy actions to insure against the risk of costly contagion from financial markets to the real economy. On August 10, in response to a sharp rise in the demand for liquidity, the Fed injected $38 billion in reserves via open market trading. In one sense, this was a routine action to inject sufficient reserves to maintain the target federal funds rate at 5-1/4 percent—the non-routine part was the size of the injection required to do so. (Indeed, this was the largest such injection since 9/11.)

Kohn fully understands monetary operations and would not/did not make a statement like this.

On August 16, with conditions having deteriorated further, the Federal Reserve Board, in consultation with the District Reserve Banks, moved to improve the functioning of money markets by cutting the discount rate by 50 basis points and extended the allowable term for discount window loans to 30 days. The Board also reiterated the Fed’s policy that high-quality ABCP is acceptable collateral for borrowing at the discount window. At its regular meeting on September 18, the FOMC cut the federal funds rate 50 basis points and then lowered it another 25 basis points at its meeting in October. Related actions by the Board of Governors lowered the discount rate to 5 percent. Finally, just yesterday the Open Market Desk at the New York Fed announced that it will conduct longer-term repurchase agreements extending into January 2008 with an eye toward meeting additional liquidity needs in money markets.

Again, note the contrast with Kohn’s discussion of the ramifications of the discount rate moves.

After the October moves, the FOMC press release noted: “Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.” The Committee also assessed that “the upside risks to inflation roughly balanced the downside risks to growth.” My reading of the data since then continues to support this risk assessment. As of today, I feel that the stance of monetary policy is consistent with achieving our dual mandate objectives and will help promote well-functioning financial markets.

Meaning that if the meeting were today, he wouldn’t recommend a cut.

Indeed, the FOMC minutes released on November 20 included new information on economic projections for 2007-10. The committee will release updated projections four times a year. Both the range and central tendencies of these projections envision growth returning to potential in 2009 and 2010, and inflation being within ranges that many members view as consistent with price stability.

Again, current stance appropriate given the forecasts and current conditions.

The Outlook Going Forward

Of course, there is still a good deal of uncertainty over how events will play out over time, and we are monitoring conditions closely for developments that may change our assessments of the risks to growth and inflation. A number of major financial intermediaries have recently announced substantial losses, and housing markets are still weak and will continue to struggle next year. Home sales and new construction fell sharply last quarter, and prices softened. The only data we have on home building for the current quarter are housing starts and permits: These came in well below average in October. But these weak data were not a surprise — our forecast is looking for another large decline in residential construction this quarter.

Again, the economy would have to be worse than the October 31 forecast to consider another cut, and that forecast has a decline built into it.

Outside of the financial sector and housing, the rest of the economy appears to have weathered the turmoil relatively well. The first estimate of real GDP growth in the third quarter was a quite solid 3.9 percent, and private market economists think the revised number that will be released on Thursday will be close to 5 percent. So the economy entered the fourth quarter with healthy momentum.

However, our forecast is for relatively soft GDP growth in the current quarter. Private sector forecasts seem to be in the 1 to 2 percent range. And, not surprisingly, we have seen some sluggish indicators consistent with this outlook.

The current private forecasts have been revised up if anything since October 31.

Our Chicago Fed National Activity Index suggested that growth in October was well below potential. As I just mentioned, the housing numbers point to another large drag from residential investment. Manufacturing output has fallen in two of the past three months. Consumption—by far the largest component of spending—grew at a solid rate in the third quarter, but in October, motor vehicle sales changed little and sales at other retailers also posted pretty flat numbers. Consumer sentiment also is down. But we have also received positive news. Forward-looking indicators point to further increases in business investment and continued strength in exports.

Seems to emphasize these last two as forward looking is more important than rearview mirror observations.

Importantly, the job market remains healthy—nonfarm payrolls increased 166,000 in October. Over the past four months, job growth has averaged about 115,000 per month, down from the 150,000 pace over the first half of the year, but still in line with demographic trends and an economy growing at potential.

As discussed in previous posts, the fed sees the labor force participation rate shrinking for demographic reasons. So, the unemployment rate staying low with fewer new jobs are expected and part of the forecast.

This is a key fundamental supporting the forecast because gains in employment lead to gains in income, which in turn support gains in consumer spending going forward.

Looking beyond the current quarter, our baseline forecast is for growth recovering as we move through next year.

Recovery beyond the current quarter. This shouldn’t change by the meeting.

In particular, we expect that later in 2008 economic growth will move lose to its current potential, which we at the Chicago Fed see as being slightly above 2-1/2 percent per year.

Their position is that the potential non inflationary growth is relatively low.

Now this pace for potential output growth is lower than during the 1995-2003 period. But it still includes a healthy trend in productivity growth relative to longer-term historical standards. Of course, productivity growth is a key factor supporting job growth, and with it income creation and increases in household expenditures; it also underlies the profitability of business spending. Solid demand for our exports should continue to be a plus for the economy. And we do not think residential investment will make as large of a negative contribution to overall growth as it did in 2006 and 2007.

And an early turn around could derail their hopes of any ‘slack’ in the labor markets.

There is still a good deal of uncertainty about this forecast. We can’t rule out the possibility of continued market difficulties. We can’t be sure how long it will take for financial intermediaries to complete the process of re-evaluating the risks in their portfolios. And many subprime adjustable rate mortgages will see their rates climb over the next few months—a process that could feed back on to housing and financial markets. But developments could surprise us on the
upside as well.

This risk also balanced.

The real economy has proven to be resilient to a host of serious shocks over the past twenty years. Indeed, think back to the concerns we had in 1998 about a fallout on the real economy from the financial crisis associated with the Russian default and LTCM. In fact, real GDP grew 4.7 percent in 1999, a pretty strong pace by any standard. With regard to inflation, the latest numbers have been encouraging. The 12-month change in core PCE prices remained at 1-3/4 percent in September. We do not have the PCE index for September yet, but the CPI data for October showed a moderate increase in core prices. Of course, higher food and energy prices have boosted the top-line inflation numbers, and the overall PCE prices have risen nearly 2-1/2 percent over the past year. At present, my outlook is for core PCE inflation to be in the range of 1-1/2 to 2 percent in 2008-09, and for total PCE inflation to come down and be roughly in line with the core rate. Relative to our outlook six months ago, this is a favorable development.

There are both upside and downside risks to this inflation forecast. With no appreciable slack in resource markets, cost pressures from higher unit labor costs, energy, or import prices could show through to the top-line inflation numbers. However, weaker economic activity would tend to offset these factors.

Balanced risks on inflation.

But they have to say that – their job is managing expectations.

Concluding remarks

Given the uncertainties about how financial conditions might evolve and affect the real economy, policy naturally tends to emphasize risk-management approaches. That is, the Fed must adjust the stance of policy to guard against the risk of events that may have low probability but, if they did occur, would present an especially notable threat to sustainable growth or price stability. Such risk management was an important consideration in the monetary policy reactions to the current financial situation that I talked about a few minutes ago. But while the risk is still present of notably weaker-than-expected overall economic activity, given the policy insurance we have put in place I don’t see this as likely.

Isn’t forecasting activity weaker than the October 31 forecast.

As always, our focus will continue to be to foster maximum sustainable growth while maintaining price stability.

And they all believe price stability is a necessary condition for optimal long term growth and employment.

1See Gilboa, I., and D. Schmeidler, 1989, “Maxmin Expected Utility
with non-unique Priors,” Journal of Mathematical Economics, 18,
141-153; Hansen, L., and T. Sargent, 2003, “Robust Control of
Forward-looking Models,” Journal of Monetary Economics 50(3), 581-604;
Caballero, R., and A. Krishnamurthy, 2005, “Financial System Risk and
Flight to Quality,” National Bureau of Economic Research.Working Paper
No. 11834.

2For a further discussion of these examples, see Caballero, and
Krishnamurthy, op. cit.

3See Gennotte, G. and H. Leland, 1990, “Market Liquidity, Hedging, and
Crashes,” American Economic Review, 80(5), 999-1021.

*The views presented here are my own, and not necessarily those of the
Federal Open Market Committee or the Federal Reserve System.


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Second Look at Kohn Speech

‘People can misinterpret almost anything so that it coincides with
views they already hold. They take from art what they already
believe.’ -SKubrick

Went through Kohn’s speech again and still don’t see it the way the markets do. Am I missing something?

Financial Markets and Central Banking

I thought it might be useful to start this session with a few thoughts on some of the issues facing central banks as they deal with the consequences of the recent turbulence in financial markets.1 This list is not comprehensive: I have concentrated on the issues associated with our roles as monetary policy makers and providers of liquidity–and even in that category I cannot address all the issues in the short time allotted.Like every other period of financial turbulence, this one has been marked by considerable uncertainty. Central banks, other authorities, and private-market participants must make decisions based on analyses made with incomplete information and understanding. The repricing of assets is centered on relatively new instruments with limited histories–especially under conditions of stress; many of them are complex and have reacted to changing circumstances in unanticipated ways; and those newer instruments have been held by a variety of investors and intermediaries and traded in increasingly integrated global markets, thereby complicating the difficulty of seeing where risk is coming to rest.Operating under this degree of uncertainty has many consequences. One is that the rules and criteria for taking particular actions seem a lot clearer in textbooks or to many commentators than they are to decision makers. For example, the extent to which institutions are facing liquidity constraints as opposed to capital constraints,

Yes, he recognizes the difference. Lending is not constrained by capital.

or the moral hazard consequences of policy actions, are inherently ambiguous in real time. Another consequence of operating under a high degree of uncertainty is that, more than usually, the potential actions the Federal Reserve discusses have the character of “buying insurance” or managing risk–that is, weighing the possibility of especially adverse outcomes.

Inflation risk which they believe hurts long term optimal employment and growth versus systemic risk which they have called ‘market functioning’ risk.This is some kind of unknown catastrophic shutdown of the real economy due to dependence of the real economy on the functioning of the financial sectors. The risk is both nebulous and outside of mainstream models, hence the radically elevated uncertainty that led to the last two cuts as ‘insurance’ against this ‘market functioning’ risk.From the statement after the October 31 meeting, the inflation risk and the market functioning risk were ‘balanced’. This means the elevated market functioning risk was balanced by the elevated inflation risk.

The nature of financial market upsets is that they substantially increase the risk of such especially adverse outcomes while possibly having limited effects on the most likely path for the economy.

This refers back to the ‘neutrality of money’ theorem which states that in the long run the economy is supply side constrained and monetary policy is neutral for long term grown and employment, provided the fed keeps inflation expectations ‘well contained’. If expectations are allowed to become elevated, they believe the real losses are far higher than any short term real losses due to a slowdown or recession.

Moral Hazard

Central banks seek to promote financial stability while avoiding the creation of moral hazard. People should bear the consequences of their decisions about lending, borrowing, and managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill advised.

‘People’ here for the most part means shareholders and owners. That is the source of the ‘market discipline’ that regulates the risk companies and individuals take.

At the same time, however, in my view, when the decisions do go poorly, innocent bystanders should not have to bear the cost.

In general, I think those dual objectives–promoting financial stability and avoiding the creation of moral hazard–are best reconciled by central banks’ focusing on the macroeconomic objectives of price stability and maximum employment.

That is his answer to moral hazard. And he believes that price stability is a necessary condition for optimal long term growth and employment, which is the current ‘mainstream’ economic thought as supported by all of the world’s central bankers and major universities.

This is a direct statement as to the importance of not letting inflation expectations elevate.

Asset prices will eventually find levels consistent with the economy producing at its potential, consumer prices remaining stable, and interest rates reflecting productivity and thrift.

Continuation of the neutrality of money idea – markets will adjust in the long run to the economy’s optimal output and employment, as above.

Such a strategy would not forestall the correction of asset prices that are out of line with fundamentals or prevent investors from sustaining significant losses. Losses were evident early in this decade in the case of many high-tech stocks, and they are in store for houses purchased at unsustainable prices and for mortgages made on the assumption that house prices would rise indefinitely.

With this strategy – “central banks’ focusing on the macroeconomic objectives of price stability and maximum employment” – shareholders and owners will take the losses, not the government.

To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment. But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the
population a lesson.

This is justifying the previous cuts. He is saying the fed cuts were in line with its macro objectives. This is moving a bit into the ‘reinventing monetary policy’ realm, as above, as the systemic risks they fear are not in their models nor in mainstream considerations.

Additionally, there is no identified ‘channel’ for the rate cuts to alter ‘market functioning’ apart from the ‘psychological’ considerations, while the fed identifies several ‘channels’ that connect rate cuts to higher inflation.

That’s where all the talk of being ‘quick to take the cuts back’ comes from several fed participants.

The design of policies to achieve medium-term macroeconomic stability can affect the incentives for future risk-taking. To minimize moral hazard, central banks should operate as much as possible through general instruments not aimed at individual institutions. Open market operations fit this description,

Correctly affirming open market operations are not ‘bailouts’ but not going as far as to explain how the merely ‘offset operation factors’. Probably not enough time to get all that in.

but so, too, can the discount window when it is structured to make credit available only to clearly solvent institutions in support of market functioning.

This reads to me like a prelude to a discount cut and removal of the ‘stigma’ as we recommended last week. The first step is to recognize that it’s operationally in no way a bail out for weak or insolvent banks. Nor does it help them economically in any way but only aids market functioning.

The Federal Reserve’s reduction of the discount rate penalty by 50 basis points in August followed this model. It was intended not to help particular institutions but rather to open up a source of liquidity to the financial system to complement open market operations, which deal with a more limited set of counter parties and collateral.

As above.

The Effects of Financial Markets on the Real Economy Related developments in housing and mortgage markets are a root cause of the financial market turbulence. Expectations of ever-rising house prices along with increasingly lax lending standards, especially on subprime mortgages, created an unsustainable dynamic, which is now reversing.

He recognizes it is indeed reversing.

In that reversal, loss and fear of loss on mortgage credit have impaired the availability of new mortgage loans, which in turn has reduced the demand for housing and put downward pressures on house prices, which have further damped desires to lend. We are following this trajectory closely,

Yes, and for quite a while. Note the word ‘trajectory’ as a downward path was built into the October 31 statement.

but key questions for central banks, including the Federal Reserve, are, What is happening to credit for other uses, and how much restraint are financial market developments likely to exert on demands outside the housing sector?

looking for ‘spillover.’

Some broader repricing of risk is not surprising or unwelcome in the wake of unusually thin rewards for risk taking in several types of credit over recent years. And such a repricing in the form of wider spreads and tighter credit standards at banks and other lenders would make some types of credit more expensive and discourage some spending, developments that would require offsetting policy actions, other things being equal. Some restraint on demand from this process was a factor I took into account when I considered the economic outlook and the appropriate policy responses over the past few months.

They already have forecast some ‘restraint on demand’.

An important issue now is whether concerns about losses on mortgages and some other instruments are inducing much greater restraint and thus constricting the flow of credit to a broad range of borrowers by more than seemed in train a month or two ago.

Right, have things gotten worse since October 31?

In general, nonfinancial businesses have been in very good financial condition; outside of variable-rate mortgages, households are meeting their obligations with, to date, only a little increase in delinquency rates, which generally remain at low levels. Consequently, we might expect a moderate adjustment in the availability of credit to these key spending sectors. However, the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses.

There is a possibility of turbulence resulting in further tightening of financial conditions. This is not stated as a certainty.

Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well.

Again, ‘could’ be a source of reduced demand. Again not a certainty.

Liquidity Provision and Bank Funding Markets Central banks have been confronting several issues in the provision of liquidity and bank funding. When the turbulence deepened in early August, demands for liquidity and reserves pushed overnight rates in interbank markets above monetary policy targets. The aggressive provision of reserves by a number of central banks met those demands, and rates returned to targeted levels. In the United States, strong bids by foreign banks in the dollar-funding markets early in the day have complicated our management of this rate.

Note that this is Euro banks that have been bidding up LIBOR.

And demands for reserves have been more variable and less flexible in an environment of heightened uncertainty, thereby adding to volatility.

This is a weakness in the NY fed’s ‘toolbox’ that he knows about but doesn’t want to directly criticize. Instead he offers remedies.

In addition, the Federal Reserve is limited in its ability to restrict the actual federal funds rate within a narrow band because we cannot, by law, pay interest on reserves for another four years.

Supporting the measure now before congress to allow the fed to pay interest on reserves. This would assist the NY fed in keeping the fed funds rate at the target set by the FOMC.

At the same time, the term interbank funding markets have remained unsettled. This is evident in the much wider spread between term funding rates–like libor–and the expected path of the federal funds rate. This is not solely a dollar-funding phenomenon–it is being experienced in euro and sterling markets to different degrees. Many loans are priced off of these term funding rates, and the wider spreads are one development we have factored into our easing actions.

Defending past easings on the notion that even though fed funds are lower, to many the cost of funds is based on LIBOR which hasn’t gone down as much as the fed funds rate.

Moreover, the behavior of these rates is symptomatic of caution among key marketmakers about taking and funding positions, and this is probably impeding the reestablishment of broader market trading liquidity.

The fed funds/LIBOR spread is part of the liquidity problem.

Conditions in term markets have deteriorated some in recent weeks. The deterioration partly reflects portfolio adjustments for the publication of year-end balance sheets. Our announcement on Monday of term open market operations was designed to alleviate some of the concerns about year-end pressures.

Yes, much of the spread is not a year end issue.

The underlying causes of the persistence of relatively wide-term funding spreads are not yet clear. Several factors probably have been contributing. One may be potential counterparty risk while the ultimate size and location of credit losses on subprime mortgages and other lending are yet to be determined. Another probably is balance sheet risk or capital risk–that is, caution about retaining greater control over the size of balance sheets and capital ratios given uncertainty about the ultimate demands for bank credit to meet liquidity backstop and other obligations. Favoring overnight or very short-term loans to other depositories and limiting term loans give banks the flexibility to reduce one type of asset if others grow or to reduce the entire size of the balance sheet to maintain capital leverage ratios if losses unexpectedly subtract from capital. Finally, banks may be worried about access to liquidity in turbulent markets. Such a concern would lead to increased demands and reduced supplies of term funding, which would put upward pressure on rates.

This last concern is one that central banks should be able to address. The Federal Reserve attempted to deal with it when, as I already noted, we reduced the penalty for discount window borrowing 50 basis points in August and made term loans available.

That was a few days after we suggested it.

The success of such a program lies not in loans extended but rather in the extent to which the existence of this facility helps reassure market participants. In that regard, I think we had some success, at least for a time.

Yes, kept some of a lid on FF/LIBOR of around 50 bp plus the ‘stigma’ explained below.

But the usefulness of the discount window as a source of liquidity has been limited in part by banks’ fears that their borrowing might be mistaken for accessing emergency loans for troubled institutions. This “stigma” problem is not peculiar to the United States, and central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress.

A prelude to removing the ‘stigma’ as we also suggested a few days ago.

Conclusion

In response to developments in financial markets, the Federal Reserve has adjusted the stance of monetary policy and the parameters of how we supply liquidity to banks and the financial markets.

In this ‘conclusion’, he turns attention away to *how* they supply liquidity.

These adjustments have been designed to foster price stability and maximum sustainable growth and to restore better functioning of financial markets in support of these economic objectives. My discussion today was intended to highlight some of the issues we will be looking at in financial markets as we weigh the necessity of future actions.

Weigh the balance of risks, and how to address them.

We will need to assess the implications of these developments, along with the vast array of incoming information on economic activity and prices, for the future path of the U.S. economy. As the Federal Open Market Committee noted at its last meeting, uncertainties about the economic outlook are unusually high right now. In my view, these uncertainties require flexible and pragmatic policymaking–nimble is the adjective I used a few weeks ago. In the conduct of monetary policy, as Chairman Bernanke has emphasized, we will act as needed to foster both price stability and full employment.

To me, this speech adds up to a discount rate cut and removal of the stigma to foster liquidity and market functioning.

Price stability means no FF cut – the 75 bp ‘insurance’ has already been carried what they see as a high premium as inflation risks have elevated substantially since October 31, and CPI will likely be going through 4% year over year a few days after the meeting.

Full employment also means price stability, as price stability is a necessary condition for max long term employment.

Comments welcome – please send to others for their comments as well.


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