Tuesday, September 11, 2007

Yellen on the Economic Outlook

Janet Yellen, the San Francisco Fed President and current FOMC non-voter, gave a speech today on "Recent Financial Developments and the U.S. Economic Outlook."

Before we get into this particular speech, you should know that I really like Dr. Yellen's speeches. She gives the best general speeches of anyone on the FOMC, hands down. They're deeply informed, highly readable, frequently entertaining (really) and they invariably manage to cut to the heart of even the most complicated situations. In short, they cut through the noise.

And, on top of that, she's a professor at my graduate school alma mater (go Bears!).

Now, on to the speech. Frankly, it's so concise and well-written that excerpting it seems counter-productive. You really should read the whole thing. Nevertheless, I've got a few points I want to highlight.

The first half of the speech reviews recent events in both the credit markets and the broader economy. The gloom and doom have been so widespread, at least on Wall Street, that what struck me first was the silver-lining to her speech:

First, she points out that credit conditions have not tightened for everyone:

On the corporate side, prime borrowers have experienced little change in their borrowing costs....

In mortgage markets ... borrowing rates for low-risk conforming mortgages have actually decreased somewhat....

So what's the problem?

[S]ome markets have become downright illiquid; in other words, the markets themselves are not functioning efficiently, or may not be functioning much at all. This illiquidity has become an enormous problem for companies that specialize in originating mortgages and then bundling them to sell as securities.
What should the Fed be doing?
The Fed has three main responsibilities that pertain to these developments: promoting financial stability to help financial markets function in an orderly way, supervising and regulating banks and bank holding companies to ensure the safety and soundness of the banking system, and conducting monetary policy to achieve its congressionally mandated goals of price stability and maximum sustainable output and employment.
Notice the order? First promote stability, then supervise and regulate banks, and last (last!) conduct monetary policy (i.e. fiddle with the Fed Funds rate).

When should the Fed use monetary policy?
For the conduct of monetary policy, the main question is how recent financial developments and other economic factors affect the outlook for the U.S. economy and the risks to that outlook. The reason this is the main question is that monetary policy’s unswerving focus should be on pursuing the Fed’s mandated goals of price stability and full employment. Monetary policy should not be used to shield investors from losses.
OK, easy enough. So has the economic outlook changed?
Despite the hike in borrowing costs for higher-risk corporate borrowers ... 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.
But it's not all rosy:
That said, financial market turmoil seems likely to intensify the downturn in housing.

Beyond the housing sector’s direct impact on GDP growth, a significant issue is its impact on personal consumption expenditures, which have been the main engine of growth in recent years.... A drop in house prices is likely to restrain consumer spending to some extent....

A big issue is whether developments in the relatively small housing sector will spread to the large consumption sector, perhaps through declines in house prices. Should the decline in house prices occur in the context of rising unemployment, the risks could be significant.
But that's enough gloom... back to the silver lining:
We should remember that conditions can change quickly for better or for worse—especially in financial markets—so it’s hard right now to speak with a great deal of confidence about future economic developments. It’s also important to maintain a sense of perspective: past experience does show that financial turbulence can be resolved more quickly than seems likely when we’re in the middle of it. Moreover, the effects of these disruptions can turn out to be surprisingly small. A good example is the aftermath of the Russian debt default in 1998. Many forecasters predicted a sharp economic slowdown as a result; but instead, growth turned out to be robust.
Then, just when you think you know where she's going with this, we read this:

On the same day [the Fed cut the discount rate, Aug 17], the Fed also issued a new statement on monetary policy, which said, and I quote: “although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably.” This assessment apparently is similar to that of market participants. Investors’ perceptions of increased downside risks have resulted in a notable decline in the rates on federal funds futures contracts and their counterparts abroad. The statement emphasized that the Committee is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

I had to read that three times, because I didn't quite believe it the first two times. Now Janet Yellen isn't an FOMC voter this year, but her opinions are taken seriously and her voice carries a lot of weight. She just said the FOMC agrees with the Fed Funds options market, which is currently pricing in these odds for cuts:

So despite all the talk of using other policy options to deal with the credit market illiquidity, it sounds to me like there's going to be a very lively debate at the FOMC about whether to cut the Fed Funds rate 25bps or 50 bps. I'm guessing Janet Yellen in now in the 50bps camp. I'm also guessing that she thinks those 50bps should be taken away if and when the credit market liquidity problems abate, which, as she says, could happen more quickly than people expect.

Views welcome...

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