Tag Archives: Interest Rates

Bowling alley to run out of points!

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National Debt Grows $1 Million a Minute

The Associated Press
Monday 03 December 2007

Washington – Like a ticking time bomb, the national debt is an explosion waiting to happen. It’s expanding by about $1.4 billion a day – or nearly $1 million a minute.

What’s that mean to you?

It means net financial assets are growing by only that much. 1.5% of GDP isn’t enough to support our credit structure needed to sustain aggregate demand over time.

It means almost $30,000 in debt for each man, woman, child and infant in the United States.

No, it means 30,000 in net financial assets for each.

Even if you’ve escaped the recent housing and credit crunches and are coping with rising fuel prices, you may still be headed for economic misery, along with the rest of the country.

Yes!

That’s because the government is fast straining resources needed to meet interest payments on the national debt, which stands at a mind-numbing $9.13 trillion.

No, it’s because the deficit is too small to supply the net financial assets we need to sustain demand, given the institutional structure that removes demand via tax advantage savings programs.

And like homeowners who took out adjustable-rate mortgages, the government faces the prospect of seeing this debt – now at relatively low interest rates – rolling over to higher rates, multiplying the financial pain.

Only if the fed hikes rates.

So long as somebody is willing to keep loaning the U.S. government money, the debt is largely out of sight, out of mind.

Government securities offer us interest bearing alternative to non interest bearing reserve accounts.

But the interest payments keep compounding, and could in time squeeze out most other government spending –

Operationally, spending is totally independent of revenues. The only constraints are self imposed.

leading to sharply higher taxes or a cut in basic services like Social Security and other government benefit programs. Or all of the above.

Only if congress votes that way..

A major economic slowdown, as some economists suggest may be looming, could hasten the day of reckoning.

The national debt – the total accumulation of annual budget deficits – is up from $5.7 trillion when President Bush took office in January 2001 and it will top $10 trillion sometime right before or right after he leaves in January 2009.

Too small as it is the equity behind our credit structure.

That’s $10,000,000,000,000.00, or one digit more than an odometer-style “national debt clock” near New York’s Times Square can handle. When the privately owned automated clock was activated in 1989, the national debt was $2.7 trillion.

It is also the national ‘savings’ clock as government deficit = non government accumulation of net financial dollar assets.

It only gets worse.

So does this article.

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Over the next 25 years, the number of Americans aged 65 and up is expected to almost double. The work population will shrink and more and more baby boomers will be drawing Social Security and Medicare benefits, putting new demands on the government’s resources.

The government spends by changing the number in someone’s bank account. Spending puts the same demands on government resources as running up the score at a football game puts strain on the stadium’s resources needed to post the score.

These guaranteed retirement and health benefit programs now make up the largest component of federal spending. Defense is next. And moving up fast in third place is interest on the national debt, which totaled $430 billion last year.

All interest expense is net income to the non government sectors.

Aggravating the debt picture: the wars in Iraq and Afghanistan, which the nonpartisan Congressional Budget Office estimates could cost $2.4 trillion over the next decade

That will be an aggregate demand add. What are the subtractions going to be? Increased pension funds assets, IRA’s, insurance reserves, and all of the other tax advantage ‘savings incentives’. To date, these have dwarfed government deficit spending and resulted in a chronic shortage of aggregate demand and massive economic under performance.

Despite vows in both parties to restrain federal spending, the national debt as a percentage of the U.S. Gross Domestic Product has grown from about 35 percent in 1975 to around 65 percent today.

Last I heard it was still 35%? But, as above, whatever it is, it is still not sufficient to support demand at ‘full employment’ levels. Our employment rate assumes large chunks of the population aren’t working because they don’t want to and wouldn’t work if desirable jobs were offered to them. The experience of the lat 90’s shows this isn’t true. With the right paid jobs available, employment could increase perhaps by 10%.

By historical standards, it’s not proportionately as high as during World War II – when it briefly rose to 120 percent of GDP, but it’s a big chunk of liability.

Didn’t seem to hurt war output!

“The problem is going forward,” said David Wyss, chief economist at Standard and Poors, a major credit-rating agency.

“Our estimate is that the national debt will hit 350 percent of the GDP by 2050 under unchanged policy. Something has to change, because if you look at what’s going to happen to expenditures for entitlement programs after us baby boomers start to retire, at the current tax rates, it doesn’t work,” Wyss said.

The only thing that ‘doesn’t work’ is the 10% of the work force that is kept on the sidelines by too tight fiscal policy.

With national elections approaching, candidates of both parties are talking about fiscal discipline and reducing the deficit and accusing the other of irresponsible spending.

Yes, and that is the biggest continuing systemic risk to the real economy – not a bunch of write downs in the financial sector.

But the national debt itself – a legacy of overspending dating back to the American Revolution – receives only occasional mention.

Who is loaning Washington all this money?

Who has all the money looking to buy government securities is the right question. And it’s the same funds that come from deficit spending. Deficit spending is best thought of as government first spending, then selling securities to provide those funds with a place to earn interest. The fed calls that process ‘offsetting operating factors’.

Ordinary investors who buy Treasury bills, notes and U.S. savings bonds, for one. Also it is banks, pension funds, mutual fund companies and state, local and increasingly foreign governments. This accounts for about $5.1 trillion of the total and is called the “publicly held” debt.

It’s also called the total net financial assets of non government sectors when you add cash in circulation and reserve balances kept at the fed.

The remaining $4 trillion is owed to Social Security and other government accounts, according to the Treasury Department, which keeps figures on the national debt down to the penny on its Web site.

Intergovernment transfers have no effect on the non government sectors’ aggregate demand.

Some economists liken the government’s plight to consumers who spent like there was no tomorrow – only to find themselves maxed out on credit cards and having a hard time keeping up with rising interest payments.

Those economist have it totally backwards and are a disgrace to the profession.

“The government is in the same predicament as the average homeowner who took out an adjustable mortgage,” said Stanley Collender, a former congressional budget analyst and now managing director at Qorvis Communications, a business consulting firm.

Wrong.

Much of the recent borrowing has been accomplished through the selling of shorter-term Treasury bills. If these loans roll over to higher rates, interest payments on the national debt could soar.

Wrong. The fed sets short term rates, not markets, and long term rates as well if it wants to.

Furthermore, the decline of the dollar against other major currencies is making Treasury securities less attractive to foreigners – even if they remain one of the world’s safest investments.

For now, large U.S. trade deficits with much of the rest of the world work in favor of continued foreign investment in Treasuries and dollar-denominated securities. After all, the vast sums Americans pay – in dollars – for imported goods has to go somewhere.

He’s getting warmer with that last bit!

But that dynamic could change.

“The first day the Chinese or the Japanese or the Saudis say, `we’ve bought enough of your paper,’ then the debt – whatever level it is at that point – becomes unmanageable,” said Collender.

Define ‘unmanageable’ please.

A recent comment by a Chinese lawmaker suggesting the country should buy more euros instead of dollars helped send the Dow Jones plunging more than 300 points.

Ok.

The dollar is down about 35 percent since the end of 2001 against a basket of major currencies.

Ok. Is that all there is to ‘unmanageable’? How about 10 year treasuries coming down below 4% as the dollar went down? How does he reconcile that?

Foreign governments and investors now hold some $2.23 trillion – or about 44 percent – of all publicly held U.S. debt. That’s up 9.5 percent from a year earlier.

Point?

Japan is first with $586 billion, followed by China ($400 billion) and Britain ($244 billion). Saudi Arabia and other oil-exporting countries account for $123 billion, according to the Treasury.

“Borrowing hundreds of billions of dollars from China and OPEC puts not only our future economy, but also our national security, at risk.

In what way? This is nonsense.

It is critical that we ensure that countries that control our debt do not control our future,” said Sen. George Voinovich of Ohio, a Republican budget hawk.

They already don’t. We control their future. Their accumulated funds are only worth what we want them to be. We control the price level. They are the ones at risk.

Of all federal budget categories, interest on the national debt is the one the president and Congress have the least control over. Cutting payments would amount to default, something Washington has never done.

Why would they? Functionally that’s a tax, and there are sufficient legal tax channels. So why use an illegal one?

Congress must from time to time raise the debt limit – sort of like a credit card maximum – or the government would be unable to borrow any further to keep it operating and to pay additional debt obligations.

Yes, that is a self-imposed constraint, not inherent in the monetary system that needs to go. If congress has approved the spending, that is sufficient.

The Democratic-led Congress recently did just that, raising the ceiling to $9.82 trillion as the former $8.97 trillion maximum was about to be exceeded. It was the fifth debt-ceiling increase since Bush became president in 2001.

Democrats are blaming the runup in deficit spending on Bush and his Republican allies who controlled Congress for the first six years of his presidency.

Not that I approve of the specifics of his tax cuts and spending increase, but good thing he did run up the deficit or we would be in the middle of a much worse economy.

They criticize him for resisting improvements in health care, education and other vital areas while seeking nearly $200 billion in new Iraq and Afghanistan war spending.

Different point.

“We pay in interest four times more than we spend on education and four times what it will cost to cover 10 million children with health insurance for five years,” said House Speaker Nancy Pelosi, D-Calif. “That’s fiscal irresponsibility.”

She is way out of paradigm. We can ‘afford’ both if the real excess capacity is there without raising taxes.

Republicans insist congressional Democrats are the irresponsible ones. Bush has reinforced his call for deficit reduction with vetoes and veto threats and cites a looming “train wreck” if entitlement programs are not reined in.

Both sides are pathetic.

Yet his efforts two years ago to overhaul Social Security had little support, even among fellow Republicans.

It was ridiculous. There is no solvency risk with social security or any other government spending requirement. Only a potential inflation risk. And the total lack of discussion regarding that is testimony to the total lack of understanding of public finance.

The deficit only reflects the gap between government spending and tax revenues for one year. Not exactly how a family or a business keeps its books.

Even during the four most recent years when there was a budget surplus, 1998-2001, the national debt ranged between $5.5 trillion and $5.8 trillion.

As in trying to pay off a large credit-card balance by only making minimum payments, the overall debt might be next to impossible to chisel down appreciably, regardless of who is in the White House or which party controls Congress, without major spending cuts, tax increases or both.

“The basic facts are a matter of arithmetic, not ideology,” said Robert L. Bixby, executive director of the Concord Coalition, a bipartisan group that advocates eliminating federal deficits.

Deficit terrorists.

There’s little dispute that current fiscal policies are unsustainable, he said.

Sad but true.

“Yet too few of our elected leaders in Washington are willing to acknowledge the seriousness of the long-term fiscal problem and even fewer are willing to put it on the political agenda.”

Fortunately!!!

Polls show people don’t like the idea of saddling future generations with debt, but proposing to pay down the national debt itself doesn’t move the needle much.

Our poor kids are going to have to send the real goods and services back in time to pay off the debt???? WRONG! Each generation gets to consume the output they produce. None gets sent back in time to pay off previous generations.

“People have a tendency to put some of these longer term problems out of their minds because they’re so pressed with more imminent worries, such as wages and jobs and income inequality,” said pollster Andrew Kohut of the nonpartisan Pew Research Center.

Good!

Texas billionaire Ross Perot made paying down the national debt a central element of his quixotic third-party presidential bid in 1992. The national debt then stood at $4 trillion and Perot displayed charts showing it would soar to $8 trillion by 2007 if left unchecked. He was about a trillion low.

Fortunately!

Not long ago, it actually looked like the national debt could be paid off – in full. In the late 1990s, the bipartisan Congressional Budget Office projected a surplus of a $5.6 trillion over ten years – and calculated the debt would be paid off as early as 2006.

That therefore projected net financial assets for the non government sectors would fall that much. Not possible!!! Causes recession long before that and the countercyclical tax structure fortunately builds up deficit spending (unfortunately via falling government revenue due to unemployment and lower profits) sufficiently to ‘automatically’ trigger a recovery.

Former Fed chairman Alan Greenspan recently wrote that he was “stunned” and even troubled by such a prospect. Among other things, he worried about where the government would park its surplus if Treasury bonds went out of existence because they were no longer needed.

Not to worry. That surplus quickly evaporated.

As above.

Mark Zandi, chief economist at Moody’s Economy.com, said he’s more concerned that interest on the national debt will become unsustainable than he is that foreign countries will dump their dollar holdings – something that would undermine the value of their own vast holdings. “We’re going to have to shell out a lot of resources to make those interest payments.

Interest payments do not involve government ‘shelling out resources’ but only changing numbers in bank accounts. ‘Unsustainable’ is not applicable.

There’s a very strong argument as to why it’s vital that we address our budget issues before they get measurably worse,” Zandi said.

“Of course, that’s not going to happen until after the next president is in the White House,” he added.

Might be longer than that.

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Where the fed is vulnerable to the press

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While Fed gov Fisher was correct in stating the Fed isn’t held hostage to market pricing of fed funds when it makes its decision, the Fed is vulnerable to manipulation when it comes to inflation expectations.

Under mainstream theory, the ultimate cause of inflation is entirely attributed to the elevation of inflation expectations. The theory explains that price increases remain ‘relative value stories’ until inflation expectations elevate and turn the relative value story into an inflation story.

So far the Fed sees the price increases of recent years as relative value stories, as headline CPI has not been seen to leak into core. However, with capacity utilization high and unemployment low, the risk of inflation expectations elevating is heightened.

The Fed also knows that if the financial press starts harping on how high inflation is going, starts to intensely question Fed credibility, and calls the Fed soft on inflation, etc. etc. this process per se is capable of raising inflation expectations and potentially triggering accelerating inflation.

Therefore, I anticipate extended discussion at the meeting regarding ‘managing inflation expectations.’

And if they do cut the ff rate it will mean they continue to blinded by ‘market functioning’ risk and not willing to take the risk of not meeting market expectations of the cut.

Note the rhetoric of the financial press continues to turn in front of the meeting. First strong economy stories, then inflation stories, note this:

Bernanke May Risk `Fool in the Shower’ Label to Avert Recession

 

By Rich Miller

 

Dec. 10 (Bloomberg) — Federal Reserve Chairman Ben S. Bernanke may have to risk becoming the proverbial “fool in the shower” to keep the U.S. economy out of recession.

 

Renewed turbulence in financial markets puts Bernanke, 53, under pressure to open the monetary spigots wider to pump up the economy. Traders in federal funds futures are betting it’s a certainty the Fed will cut its benchmark interest rate from 4.5 percent tomorrow, and they see a better-than-even chance the rate will be 3.75 percent or below by April.

 

“The Fed has to assure the markets that it’s ready to ride to the rescue and cut rates by as much as necessary,” says Lyle Gramley, a former Fed governor who’s now a senior economic adviser in Washington for the Stanford Group Co., a wealth- management firm.

 

The danger of such a strategy is that Bernanke may become like the bather, in an analogy attributed to the late Nobel- Prize-winning economist Milton Friedman, who gets scalded after turning the hot water all the way up in a chilly shower. The monetary-policy equivalent would be faster inflation or another asset bubble in the wake of aggressive Fed action to tackle the slowdown in the economy.

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Strong $ AND strong yuan?

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Reminds me of the guy who loves money and wants to abolish taxes.

I do think the push is now for a stronger $, however, and we’ll see tomorrow if the Fed is on board.

As a friend of mine pointed out, a firming $ will likely trigger domestic and international portfolio reallocations back towards US equities.

Paulson Push for Stronger Yuan Weakened by Global M&A (Update3)

By Aaron Pan and Belinda CaoDec. 10 (Bloomberg)

As U.S. Treasury Secretary Henry Paulson visits China this week to push for faster appreciation of the yuan, the bigger issue may be what China is doing to strengthen the dollar.

Paulson’s fifth trip to the nation as Treasury Secretary has taken on added urgency as the U.S. grows more dependent on the dollar’s decline to lift exports and keep the economy out of recession. While the pace of the yuan’s gains tripled in the past 15 months, Chinese officials now plan to increase investments in America that may boost the U.S. currency instead.

“China at this stage needs to be looking to opportunities provided by the weakening U.S. dollar,” Ha Jiming, chief economist in Beijing at China International Capital Corp., the nation’s largest investment bank, said in an interview last week. “Very recently the government is becoming more interested in channeling money out of the country.”

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Balance of risks revisited

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“I don’t think that’s fair because I don’t — again, I think I’ve been pretty clear in saying we have an economy in the US that is fundamentally healthy. I think the jobs numbers today showed an economy that is fundamentally healthy. We’ve got very strong demand outside of the US. We’ve got exports growing, employment strong, inflation is contained. There are some risks, and I’m focused on those risks. That’s my job, and the biggest risk we have is housing and housing is a big drag on our economy and still, we’re going through a turbulent time in the capital markets. That’s a risk so we’re focused on the risks, but let’s not forget that we have a healthy economy.”
-Paulson

Two days before the Fed meeting Paulson is making the case that the economy is strong and he says the risks are *his job* and not the Fed’s job. Also, he said we have a strong $ policy after being silent on that for several months or more. No cut in the fed funds rate Tuesday would support his statements.
This article is the consensus view that’s pricing in a 25 cut on Tuesday.

US Fed seems poised to lower interest rates again at its meeting Tuesday

By JEANNINE AVERSA updated 6:46 a.m. ET, Sun., Dec. 9, 2007 WASHINGTON

A lot has changed since the U.S. Federal Reserve hinted two months ago that it might be finished cutting interest rates for a while. Credit has become harder to obtain,

Not true per se. Some spreads have widened, but absolute levels for mortgages, for example, are lower, and good credits are getting LIBOR minus funding in the bond markets. Yes, funding is more difficult and more expensive for ‘Wall Street’, but ‘Main Street’ borrowing needs are being met at reasonable terms.

Wall Street has convulsed again,

Stocks are generally up recently, and up for the year.

and the housing slump has intensified.

Maybe modestly, with some indicators flat to higher. Prices down for the quarter but YoY prices still higher as reported by the two broader measures.

As a result, policymakers at the central bank now appear to have changed their minds about the need to drop interest rates again.

Yes, that’s the appearance as seen by the financial press. (I haven’t read it that way.)

The Fed had cut rates twice this year and officials suggested in October that might be enough to help the economy survive the credit and housing stress.

And immediately afterward in several speeches as fed officials attempted unsuccessfully to take the cut out of Jan FF futures.

Then the problems snowballed,

There were no ‘snowballing problems’ only some spread widening even as absolute rates were generally lower and LIBOR rates going up over the next ‘turn’ at year end.

leading Fed Chairman Ben Bernanke to signal that one more cut might be needed.

Again, that’s how the financial press heard him. They never even reported firm the firm talk on inflation risks becoming elevated. The attitude is anything the fed says about inflation is just talk they have to say and that they don’t mean and not worth reporting.

Analysts expect the Fed to trim its key rate, now at 4.5 percent, by one-quarter of a percentage point at the meeting Tuesday. Some even speculate about the possibility of a half-point cut.

Yes, that’s the consensus.

Banks, financial companies and other investors who made loans to people with spotty credit

and fraudulent applications

or put money into securities backed by those subprime mortgages have lost billions of dollars (euros). Investors in the U.S. and abroad have grown more wary of buying new debt, thereby aggravating the credit crunch.

Yes. But again, ‘Main Street’ still remains well funded at reasonable terms.

All this has added to the turmoil on Wall Street, and Bernanke and other Fed officials say they must take it into account when deciding their next move.

Yes. And the economic numbers have come in strong enough for markets to take up to 35 bp out of the Eurodollars and nearly eliminate pricing in a 50 cut in the last few trading days.

But does lowering rates mean the Fed essentially is bailing out investors or encouraging more sloppy decision-making? In other words, what exactly is the Fed’s job?

Bernanke and other Fed officials say it is to make policy that keeps the economy growing and inflation low, a stable climate that benefits individuals, businesses and investors. The Fed also has a responsibility to ensure the banking system is sound and financial markets run smoothly.

Yes, exactly.

“There is a link between Wall Street and Main Street. The Fed is taking the right actions, but they should be careful,” said Victor Li, an economics professor at the Villanova School of Business.

That implies the question is whether the ‘market functioning’ risk is higher than the inflation risk, which is what the fed was addressing with the last two cuts.

This time ‘market functioning’ risk rhetoric has taken a back seat to ‘economic weakness’ risk rhetoric.
One more story of note:

Fed’s Inflation Measure Says Rates Can’t Fall as Traders Expect

By Liz Capo McCormick and Sandra Hernandez

Dec. 10 (Bloomberg) — The key to whether the Federal Reserve continues to cut interest rates after this week may hang on the wall behind economist Brian Sack’s desk in Washington.

Sack, head of monetary and financial market analysis at the Fed in 2003 and 2004, uses a chart that plots forward rates measuring investor expectations for inflation in five years. The gauge is so accurate that Sack and his colleagues persuaded the central bank to use it to help set policy. The chart is autographed by former Fed Chairman Alan Greenspan.

Right now, it shows current Fed Chairman Ben S. Bernanke may have less room to lower borrowing costs than investors in Treasuries anticipate, potentially setting bondholders up for a fall. The expected inflation rate, which Sack says replicates what Fed officials use, reached 2.91 percent last week, the highest since 2004, when the central bank began the first of an unprecedented 17 rate increases. The measure was at 2.79 percent on Nov. 1.

“One of the defining features of the Bernanke Fed to date is its emphasis on measures of longer-term inflation expectations,” said Sack, whose partners at Macroeconomic Advisors include former Fed Governor Laurence Meyer. “The Fed is willing to tolerate short-run movements in inflation, but only as long as those movements don’t appear to be dislodging long-run inflation expectations.”

Any evidence that accelerating inflation is becoming entrenched may heighten the Fed’s debate as policy makers consider cutting rates to keep the worst housing market in 16 years and mounting losses in securities related to subprime mortgages from tipping the economy into recession.

`Inflationary Pressures’

The gauge used by Sack, dubbed the five-year five-year forward breakeven inflation rate, suggests bets on lower Fed funds rates may be too bold.

Sack and other analysts derive the measure of inflation expectations from yields on five- and 10-year Treasury Inflation Protected Securities and Treasuries.

Five-year TIPS yield 2.15 percentage points less than five- year notes. This so-called breakeven rate is the average inflation rate investors expect over the next five years. The forward rate projects what the breakeven will be in five years, smoothing blips in inflation expectations from swings in oil prices or other events.

The five-year TIPS’ breakeven rate rose to a six-month high of 2.47 percent Nov. 27, the week after oil climbed to a record $99.29 a barrel, from about 1.9 percent on Aug. 31. As crude fell to a six-week low on Dec. 6, the breakeven rate declined and Sack’s measure dropped to 2.85 percent.

Bernanke mentioned the forward rate in a 2004 speech. Simon Kwan, a vice president at the San Francisco Fed, singled out the measure in a 2005 report, saying it “captures the market’s assessment of how well the Federal Reserve promotes price stability in the long run.”

Gaining Steam

Most analysts expect the economy to gain steam through 2008. Growth will slow to 1.5 percent this quarter from a 4.9 percent annual rate last quarter, and rise to 2.6 percent by 2009, according to the median forecast in a Bloomberg survey from Nov. 1 to Nov. 8.

The dollar, which is poised to depreciate against the euro for a second straight year, is also fueling inflation concerns. The currency’s drop and oil’s climb pushed import prices up 1.8 percent in October, the most in 17 months.

The government may say this week that consumer prices, which set TIPS rates, increased 4.1 percent last month from this year’s low of 2 percent in August and the biggest rise since July 2006, according to the median estimate of 19 economists. Food, imports and energy prices may raise inflation expectations, Bernanke said in a Nov. 30 speech in Charlotte, North Carolina.

To contact the reporter on this story:
Liz Capo McCormick in New York at Emccormick7@bloomberg.net ;
Sandra Hernandez in New York at shernandez4@bloomberg.net .

Last Updated: December 9, 2007 10:58 EST

‘The numbers’ could be used to support most anything the fed might do.The inflation numbers are both more than strong enough to support a hike, with CPI due to be reported north of 4.1 on December 14, and core moving up out of ‘comfort zones’ as well, not to mention ‘prices paid’ surveys higher and higher import and export with the weak $. Add to that the recent strong economic data – employment, CEO survey, and even car sales up a tad, etc. etc.

Inflation can also be dismissed as ‘only food and energy’ and due to fall based on (misreading) future prices as predictors of where prices will be, leaving the door open to cuts due to both ‘market functioning’ as justified by FF/LIBOR spreads at year end and the possibility of Wall Street spilling over to Main Street by ‘forward looking models’.

I can see the fed meeting going around in circles and it will come down to whether they care about inflation or not. Most of the financial community thinks they don’t, and they may be correct.

I think they do care, and care a lot, but that fear of ‘market functioning’ was severe enough to temporarily overcome their perceived imperative to sustain and environment of low inflation. And at the October meeting, the fear of some members has subsided enough to report a dissenting vote, along with half the regional banks voting against a cut.

I do think that if the fed cuts 25 it will be because they are afraid of what happens if they don’t as markets are already pricing in a 25 cut, even though this is what happened October 31, and Fisher said they wouldn’t price in a cut for that reason.

The Balance of Risks

So what would they anticipate if they don’t cut FF? The $ up, commodities down, stocks down, and credit spreads widening.

Is that risk less acceptable than the risk of promoting inflation and risking the elevation of inflation expectations if they do cut 25?

Then, there is the ‘compromise’ of cutting the discount rate and removing the stigma to address year end liquidity and ‘market functioning’ in general, with and/or without cutting the fed funds rate. The anticipated results would be a muted stock market reaction as FF/LIBOR spreads narrow, and hopefully, other credit spreads also narrow.

And if they cut the discount rate and don’t cut the FF rate, the $ will still be expected to go up and commodities down. And, with liquidity improved, stocks may be expected to do better as well.

But even though Kohn discussed this in his speech and others touched on the ‘liquidity versus the macro economy’ as well, there is no way to know how much consideration it may be given.

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Bank capital NOT a constraint on lending

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Here’s the response to Jan’s (Goldman) concern about lost capital constraining lending.

Bank capital grows endogenously- it’s not a constraint on lending apart perhaps from the very near term.

Banks ‘know’ the cost of capital, and the roe’s they need to make to pay for new capital.

For example, if Citi paid 11%, and they can leverage it 15 times, that’s about a .75% ‘add on’ to their cost of funds for funding loans.

With floating fx, the causation is ‘loans create deposits’ and this applies to availability of bank capital as well.

So it’s all about price, not quantity, for both loans and capital.

And banks currently do have a lot of ‘room’ for lending with current capital levels.

Like the recession, this all reminds me of the sign that says ‘free beer tomorrow.’

High oil won’t hurt gdp us as long as the producers are spending their income here.

It will hurt our standard of living and help theirs- real terms of trade and all that.

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BoC cuts rates

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Makes a lot more sense to Central Bankers to cut with a strong currency than a weak one, particularly with the strong currency keeping prices below their inflation targets.

The ECB, however, is looking at 3% cpi, and would rather not see the Fed cut, as they believe that would weaken the $ and bring more criticism from their eurozone exporters, as well as draw more agg demand away from the eurozone, making it that much more difficult politically for the ECB to act within its price stability mandate.

OTTAWA – The Bank of Canada today announced that it is lowering its target for the overnight rate by one-quarter of one percentage point to 4 1/4 per cent. The operating band for the overnight rate is correspondingly lowered, and the Bank Rate is now 4 1/2 per cent.Since the October Monetary Policy Report (MPR), there have been a number of economic and financial developments that have a bearing on the prospects for output and inflation in Canada.Consistent with the outlook in the MPR, the global economic expansion has remained robust and commodity prices have continued to be strong. The Canadian economy has been growing broadly in line with the Bank’s expectations, reflecting in large part underlying strength in domestic demand. However, both total CPI inflation and core inflation in October, at 2.4 per cent and 1.8 per cent respectively, were below the Bank’s expectations, reflecting increased competitive pressures related to the level of the Canadian dollar. The Bank now expects inflation over the next several months to be lower than was projected in the MPR. In the context of exceptional volatility in global financial markets, the Canadian dollar spiked well above parity with the U.S. dollar in November, but it has recently traded closer to the 98-cent-U.S. level assumed in the October MPR.Overall, the Canadian economy continues to operate above its production capacity. Given the strength of domestic demand and weak productivity growth, there continue to be upside risks to the Bank’s inflation projection.However, other developments since October suggest that the downside risks to the Bank’s inflation projection have increased. Global financial market difficulties related to the valuation of structured products and anticipated losses on U.S. sub-prime mortgages have worsened since mid-October, and are expected to persist for a longer period of time. In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further. There is an increased risk to the prospects for demand for Canadian exports as the outlook for the U.S. economy, and in particular the U.S. housing sector, has weakened.All these factors considered, the Bank judges that there has been a shift to the downside in the balance of risks around its October projection for inflation through 2009. In light of this shift, the Bank has decided to lower the target for the overnight rate. At its next interest rate decision in January, the Bank will assess all economic and financial developments and the balance of risks. A full projection for the economy and inflation will be published in the Monetary Policy Report Update on 24 January 2008.

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Review of Yellen Speech

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(from an interoffice email)

Karim:
Quite a long one http://www.frbsf.org/news/speeches/2007/1203.html, but here goes, with selected excerpts, headings my own.

If you don’t want to read the rest, one word describes it, DOVISH…if she was voting next week, she’d vote for 50bps.

Warren:
Agreed. Though the heightened inflation risks at the end do add some balance. This is far different from the Bernanke and Kohn speeches, and seems this is what they would have said if they held the same opinion.

Conditions are worse from 10/31/07
When the shock first hit, I expected the reverberations to subside gradually, especially in view of the easing in the stance of policy, so that by now there would have been a noticeable improvement in financial conditions. Indeed, though the reverberations have ebbed at times over the last four and a half months, since the October meeting market conditions have deteriorated again, and indications of heightened risk-aversion continue to abound both here and abroad.Mortgages in particularAlthough borrowing rates for low-risk conforming mortgages have decreased, other mortgage rates have risen, even for some borrowers with high credit ratings. In particular, fixed rates on jumbo mortgages are up on net since mid-July. Subprime mortgages remain difficult to get at any rate.Moreover, many markets for securitized assets, especially private-label mortgage-backed securities, continue to experience outright illiquidity; in other words, the markets are not functioning efficiently, or may not be functioning much at all. This illiquidity remains an enormous problem not only for companies that specialize in originating mortgages and then bundling them to sell as securities, but also for financial institutions holding such securities and for sponsors, including banks, of structured investment vehicles—these are entities that relied heavily on asset-backed commercial paper to fund portfolios of securitized assets.

To assess how financial conditions relevant to aggregate demand have changed since the shock first hit, we must consider not only credit markets but also the markets for equity and foreign exchange. These markets have hardly been immune to recent financial turbulence. Broad equity indices have been very volatile, and, on the whole, they have declined noticeably since mid-July, representing a restraint on spending.

Econ Outlook weaker than expected for longer; She’s not mincing words in this section

The fourth quarter is sizing up to show only very meager growth. The current weakness probably reflects some payback for the strength earlier this year—in other words, just some quarter-to-quarter volatility due to business inventories and exports. But it may also reflect some impact of the financial turmoil on economic activity. If so, a more prolonged period of sluggishness in demand seems more likely.

First, the on-going strains in mortgage finance markets seem to have intensified an already steep downturn in housing.

This weakness in house construction and prices is one of the factors that has led me to include a “rough patch” in my forecast for some time. More recently, however, the prospects for housing have actually worsened somewhat, as financial strains have intensified and housing demand appears to have fallen further.

Moreover, we face a risk that the problems in the housing market could spill over to personal consumption expenditures in a bigger way than has thus far been evident in the data. This is a significant risk since personal consumption accounts for about 70 percent of real GDP. These spillovers could occur through several channels. For example, with house prices falling, homeowners’ total wealth declines, and that could lead to a pullback in spending. At the same time, the fall in house prices may constrain consumer spending by changing the value of mortgage equity; less equity, for example, reduces the quantity of funds available for credit-constrained consumers to borrow through home equity loans or to withdraw through refinancing. Furthermore, in the new environment of higher rates and tighter terms on mortgages, we may see other negative impacts on consumer spending. The reduced availability of high loan-to-value ratio and piggyback loans may drive some would-be homeowners to pull back on consumption in order to save for a sizable down payment. In addition, credit-constrained consumers with adjustable-rate mortgages seem likely to curtail spending, as interest rates reset at higher levels and they find themselves with less disposable income.

Moreover, there are significant downside risks to this projection. Recent data on personal consumption expenditures and retail sales are not that encouraging. They have begun to show a significant deceleration—more than was expected—and consumer confidence has plummeted. Reinforcing these concerns, I have begun to hear a pattern of negative comments and stories from my business contacts, including members of our Head Office and Branch Boards of Directors. It is far too early to tell if we are in for a sustained period of sluggish growth in consumption spending, but recent developments do raise this possibility as a serious risk to the forecast.

Net Exports to weaken along with decoupling

I anticipate ongoing strength in net exports, but perhaps somewhat less than in recent years, since foreign activity may be somewhat weaker going forward. Some countries are experiencing direct negative impacts from the ongoing turmoil in financial markets. Others are likely to suffer indirect impacts from any slowdown in the U.S. For example, most Asian economies are now enjoying exceptionally buoyant conditions. But the U.S. and Asian economies are not decoupled, and a slowdown here is likely to produce ripple effects lowering growth there through trade linkages.

Now for the bright side-

I don’t want to give the impression that all of the available recent data have been weak or overemphasize the downside risks. There are some significant areas of strength. In particular, labor markets have been fairly robust in recent months. As I mentioned before, the growth of jobs is an important element in generating the expansion of personal income needed to support consumption spending, which is a key factor for the overall health of the economy. In addition, business investment in equipment and software also has been fairly strong, although here too, recent data suggest some deceleration. Despite the hike in borrowing costs for higher-risk corporate borrowers and the illiquidity in markets for collateralized loan obligations, it appears that financing for capital spending for most firms remains readily available on terms that have been little affected by the recent financial turmoil.

If we cut aggressively, we might grow at trend

To sum up the story on the outlook for real GDP growth, my own view is that, under appropriate monetary policy, the economy is still likely to achieve a relatively smooth adjustment path, with real GDP growth gradually returning to its roughly 2½ percent trend over the next year or so, and the unemployment rate rising only very gradually to just above its 4¾ percent sustainable level. However, for the next few quarters, there are signs that growth may come in somewhat lower than I had previously thought likely. For example, some of the risks that I worried about in my earlier forecast have materialized—the turmoil in financial markets has not subsided as much as I had hoped, and some data on personal consumption have come in weaker than expected. I continue to see the growth risks as skewed to the downside in part because increased perceptions of downside economic risk may induce greater caution by lenders, households, and firms.

Core PCE likely to slow further but still some upside risks

Turning to inflation, signs of improvement in underlying inflationary pressures are evident in recent data. Over the past twelve months, the price index for the measure of consumer inflation on which the FOMC bases its forecasts—personal consumption expenditures excluding food and energy, or the core PCE price index—has increased by 1.9 percent. Just several months ago, the twelve-month change was quite a bit higher, at nearly 2½ percent.

It seems most likely that core PCE price inflation will edge down to around 1¾ percent over the next few years under appropriate policy and the gap between total and core PCE inflation will diminish substantially. Such an outcome is broadly consistent with my interpretation of the Fed’s price stability mandate. This view is predicated on continued well-anchored inflation expectations. It also assumes the emergence of a slight amount of slack in the labor market, as well as the ebbing of the upward effects of movements in energy and commodity prices. However, we do still face some inflation risks, mainly due to faster increases in unit labor costs, the depreciation of the dollar, and the continuing upside surprises in energy prices. Moreover, labor markets have continued to surprise on the strong side. All of these factors will need to be watched carefully going forward.

♥

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Review of Kroszner Speech

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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.

♥

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Review of Bernanke Speech

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(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.

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Review of Evans Speech

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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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