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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