Ben S Bernanke: Economic outlook (Central Bank Articles and Speeches)

Page 1

Ben S Bernanke: Economic outlook

Testimony of Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal

Reserve System, before the Joint Economic Committee, US Congress, Washington DC,

24 September 2008.

* * *

Chairman Schumer, Vice Chair Maloney, Representative Saxton, and other members of the

committee, I appreciate this opportunity to discuss recent developments in financial markets

and to present an update on the economic situation. As you know, the U.S. economy

continues to confront substantial challenges, including a weakening labor market and

elevated inflation. Notably, stresses in financial markets have been high and have recently

intensified significantly. If financial conditions fail to improve for a protracted period, the

implications for the broader economy could be quite adverse.

The downturn in the housing market has been a key factor underlying both the strained

condition of financial markets and the slowdown of the broader economy. In the financial

sphere, falling home prices and rising mortgage delinquencies have led to major losses at

many financial institutions, losses only partially replaced by the raising of new capital.

Investor concerns about financial institutions increased over the summer, as mortgage-

related assets deteriorated further and economic activity weakened. Among the firms under

the greatest pressure were Fannie Mae and Freddie Mac, Lehman Brothers, and, more

recently, American International Group (AIG). As investors lost confidence in them, these

companies saw their access to liquidity and capital markets increasingly impaired and their

stock prices drop sharply.

The Federal Reserve believes that, whenever possible, such difficulties should be addressed

through private-sector arrangements – for example, by raising new equity capital, by

negotiations leading to a merger or acquisition, or by an orderly wind-down. Government

assistance should be given with the greatest of reluctance and only when the stability of the

financial system, and, consequently, the health of the broader economy, is at risk. In the

cases of Fannie Mae and Freddie Mac, however, capital raises of sufficient size appeared

infeasible and the size and government-sponsored status of the two companies precluded a

merger with or acquisition by another company. To avoid unacceptably large dislocations in

the financial sector, the housing market, and the economy as a whole, the Federal Housing

Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship, and the

Treasury used its authority, granted by the Congress in July, to make available financial

support to the two firms. The Federal Reserve, with which FHFA consulted on the

conservatorship decision as specified in the July legislation, supported these steps as

necessary and appropriate. We have seen benefits of this action in the form of lower

mortgage rates, which should help the housing market.

The Federal Reserve and the Treasury attempted to identify private-sector solutions for AIG

and Lehman Brothers, but none was forthcoming. In the case of AIG, the Federal Reserve,

with the support of the Treasury, provided an emergency credit line to facilitate an orderly

resolution. The Federal Reserve took this action because it judged that, in light of the

prevailing market conditions and the size and composition of AIG's obligations, a disorderly

failure of AIG would have severely threatened global financial stability and, consequently, the

performance of the U.S. economy. To mitigate concerns that this action would exacerbate

moral hazard and encourage inappropriate risk-taking in the future, the Federal Reserve

ensured that the terms of the credit extended to AIG imposed significant costs and

constraints on the firm's owners, managers, and creditors. The chief executive officer has

been replaced. The collateral for the loan is the company itself, together with its

BIS Review 115/2008

Page 2

subsidiaries.1

(Insurance policyholders and holders of AIG investment products are,

however, fully protected.) Interest will accrue on the outstanding balance of the loan at a rate

of three-month Libor plus 850 basis points, implying a current interest rate over 11 percent.

In addition, the U.S. government will receive equity participation rights corresponding to a

79.9 percent equity interest in AIG and has the right to veto the payment of dividends to

common and preferred shareholders, among other things.

In the case of Lehman Brothers, a major investment bank, the Federal Reserve and the

Treasury declined to commit public funds to support the institution. The failure of Lehman

posed risks. But the troubles at Lehman had been well known for some time, and investors

clearly recognized – as evidenced, for example, by the high cost of insuring Lehman's debt in

the market for credit default swaps – that the failure of the firm was a significant possibility.

Thus, we judged that investors and counterparties had had time to take precautionary

measures.

While perhaps manageable in itself, Lehman's default was combined with the unexpectedly

rapid collapse of AIG, which together contributed to the development last week of

extraordinarily turbulent conditions in global financial markets. These conditions caused

equity prices to fall sharply, the cost of short-term credit – where available – to spike upward,

and liquidity to dry up in many markets. Losses at a large money market mutual fund sparked

extensive withdrawals from a number of such funds. A marked increase in the demand for

safe assets – a flight to quality – sent the yield on Treasury bills down to a few hundredths of

a percent. By further reducing asset values and potentially restricting the flow of credit to

households and businesses, these developments pose a direct threat to economic growth.

The Federal Reserve took a number of actions to increase liquidity and stabilize markets.

Notably, to address dollar funding pressures worldwide, we announced a significant

expansion of reciprocal currency arrangements with foreign central banks, including an

approximate doubling of the existing swap lines with the European Central Bank and the

Swiss National Bank and the authorization of new swap facilities with the Bank of Japan, the

Bank of England, and the Bank of Canada, among others. We will continue to work closely

with colleagues at other central banks to address ongoing liquidity pressures. The Federal

Reserve also announced initiatives to assist money market mutual funds facing heavy

redemptions and to increase liquidity in short-term credit markets.

Despite the efforts of the Federal Reserve, the Treasury, and other agencies, global financial

markets remain under extraordinary stress. Action by the Congress is urgently required to

stabilize the situation and avert what otherwise could be very serious consequences for our

financial markets and for our economy. In this regard, the Federal Reserve supports the

Treasury's proposal to buy illiquid assets from financial institutions. Purchasing impaired

assets will create liquidity and promote price discovery in the markets for these assets, while

reducing investor uncertainty about the current value and prospects of financial institutions.

More generally, removing these assets from institutions’ balance sheets will help to restore

confidence in our financial markets and enable banks and other institutions to raise capital

and to expand credit to support economic growth.

I will now turn to a brief update on the economic situation.

Ongoing developments in financial markets are directly affecting the broader economy

through several channels, most notably by restricting the availability of credit. Mortgage

credit terms have tightened significantly and fees have risen, especially for potential

borrowers who lack substantial down payments or who have blemished credit histories.

Mortgages that are ineligible for credit guarantees by Fannie Mae or Freddie Mac – for

Specifically, the loan is collateralized by all of the assets of the company and its primary non-regulated

subsidiaries. These assets include the equity of substantially all of AIG's regulated subsidiaries.

BIS Review 115/2008

Page 3

example, nonconforming jumbo mortgages – cannot be securitized and thus carry much

higher interest rates than conforming mortgages. Some lenders have reduced borrowing

limits on home equity lines of credit. Households also appear to be having more difficulty of

late in obtaining nonmortgage credit. For example, the Federal Reserve's Senior Loan Officer

Opinion Survey reported that as of July an increasing proportion of banks had tightened

standards for credit card and other consumer loans. In the business sector, through August,

the financially strongest firms remained able to issue bonds but bond issuance by

speculative-grade firms remained very light. More recently, however, deteriorating financial

market conditions have disrupted the commercial paper market and other forms of financing

for a wide range of firms, including investment-grade firms. Financing for commercial real

estate projects has also tightened very significantly.

When worried lenders tighten credit, then spending, production, and job creation slow. Real

economic activity in the second quarter appears to have been surprisingly resilient, but, more

recently, economic activity appears to have decelerated broadly. In the labor market, private

payrolls shed another 100,000 jobs in August, bringing the cumulative drop since November

to 770,000. New claims for unemployment insurance are at elevated levels and the civilian

unemployment rate rose to 6.1 percent in August. Households' real disposable income was

boosted significantly in the spring by the tax rebate payments, but, excluding those

payments, real after-tax income has fallen this year, which partly reflects increases in the

prices of energy and food.

In recent months, the weakness in real income together with the restraining effects of

reduced credit flows and declining financial and housing wealth have begun to show through

more clearly to consumer spending. Real personal consumption expenditures for goods and

services declined in June and July, and the retail sales report for August suggests that

outlays for consumer goods fell noticeably further last month. Although the retrenchment in

household spending has been widespread, purchases of motor vehicles have dropped off

particularly sharply. On a more positive note, oil and gasoline prices – while still at high

levels, in part reflecting the effects of Hurricane Ike – have come down substantially from the

peaks they reached earlier this summer, contributing to a recent improvement in consumer

confidence. However, the weakness in the fundamentals underlying consumer spending

suggest that household expenditures will be sluggish, at best, in the near term.

The recent indicators of the demand for new and existing homes hint at some stabilization of

sales, and lower mortgage rates are likely to provide some support for demand in coming

months. Moreover, although expectations that house prices will continue to fall have probably

dissuaded some potential buyers from entering the market, lower house prices and mortgage

interest rates are making housing increasingly affordable over time. Still, homebuilders retain

large backlogs of unsold homes, which should continue to restrain the pace of new home

construction. Indeed, single-family housing starts and new permit issuance dropped further in

August. At the same time, the continuing decline in house prices reduces homeowners'

equity and puts continuing pressure on the balance sheets of financial institutions, as I have

already noted.

As of midyear, business investment was holding up reasonably well, with investment in

nonresidential structures particularly robust. However, a range of factors, including

weakening fundamentals and constraints on credit, are likely to result in a considerable

slowdown in the construction of commercial and office buildings in coming quarters.

Business outlays for equipment and software also appear poised to slow in the second half

of this year, assuming that production and sales slow as anticipated.

International trade provided considerable support for the U.S. economy over the first half of

the year. Economic activity has been buoyed by strong foreign demand for a wide range of

U.S. exports, including agricultural products, capital goods, and industrial supplies, even as

imports declined. However, in recent months, the outlook for foreign economic activity has

deteriorated amid unsettled conditions in financial markets, troubled housing sectors, and

BIS Review 115/2008

Page 4

softening sentiment. As a consequence, in coming quarters, the contribution of net exports to

U.S. production is not likely to be as sizable as it was in the first half of the year.

All told, real gross domestic product is likely to expand at a pace appreciably below its

potential rate in the second half of this year and then to gradually pick up as financial

markets return to more-normal functioning and the housing contraction runs its course. Given

the extraordinary circumstances, greater-than-normal uncertainty surrounds any forecast of

the pace of activity. In particular, the intensification of financial stress in recent weeks, which

will make lenders still more cautious about extending credit to households and business,

could prove a significant further drag on growth. The downside risks to the outlook thus

remain a significant concern.

Inflation rose sharply over the period from May to July, reflecting rapid increases in energy

and food prices. During the same period, price inflation for goods and services other than

food and energy also moved up from the low rates seen in the spring, as the higher costs of

energy, other commodities, and imported goods were partially passed through to consumers.

Recently, however, the news on inflation has been more favorable. The prices of oil and

other commodities, while remaining quite volatile, have fallen, on net, from their recent

peaks, and the dollar is up from its mid-summer lows. The declines in energy prices have

also led to some easing of inflation expectations, as measured, for example, by consumer

surveys and the pricing of inflation-indexed Treasury securities.

If not reversed, these developments, together with a pace of growth that is likely to fall short

of potential for a time, should lead inflation to moderate later this year and next year.

Nevertheless, the inflation outlook remains highly uncertain. Indeed, the fluctuations in oil

prices in the past few days illustrate the difficulty of predicting the future course of commodity

prices. Consequently, the upside risks to inflation remain a significant concern as well.

Over time, a number of factors should promote the return of our economy to higher levels of

employment and sustainable growth with price stability, including the stimulus being provided

by monetary policy, lower oil and commodity prices, increasing stability in the mortgage and

housing markets, and the natural recuperative powers of our economy. However,

stabilization of our financial system is an essential precondition for economic recovery. I urge

the Congress to act quickly to address the grave threats to financial stability that we currently

face. For its part, the Federal Open Market Committee will monitor economic and financial

developments carefully and will act as needed to promote sustainable economic growth and

price stability.

BIS Review 115/2008