*These remarks were prepared for small luncheon group in Dallas on July 29.
For perspective, the housing boom peaked in 2006. The financial fallout of tons of subprime mortgages embedded in mortgage backed securities came to the public's attention about a year ago, in July 2007. The subprime crisis became front page news in late July and early August. On August 5, the Fed's Federal Open Market Committee had a regular meeting and failed to ease policy or even to shift its focus of greatest danger away from inflation to neutral or to a greater danger from the financial crisis and its likely spillover into the real economy. In retrospect, that showed the Fed to be behind the curve.
Strong adverse market reaction in the days following woke the Fed up and its first reaction was to allow the Federal Funds rate to trade below its official target of 5.25 percent – which was termed a "stealth easing." Federal Funds are bank reserves on deposit at the Fed that are traded daily among banks. The annualized interest rate is called the Federal Funds rate, which supposedly reflects the relative scarcity of bank reserves needed for new loans and investments and new money creation.
The Fed's short run policy tool is to use open market operations in government securities to affect the level of federal funds and keep the FF rate close to its target. It understands, however, that in the long run, money supply growth is a better gage of monetary policy. The goal there is to keep the growth of the money supply in line with the capacity of the economy to grow in real terms. If the labor force growth trend is around 1 percent per year and productivity (output per hour) is growing around 3.5 to 4.0 percent per year, then the money supply should grow (adjusted for velocity changes) around 3.5 to 4.0 percent per year.
The Fed began its formal program of aggressive policy ease in early September with a surprise reduction in its discount rate of half a percentage point, enabling banks to borrow newly created reserves cheaper and hopefully passing the lower rates on to their customers. At the September 18th meeting the FOMC began a series of cuts in its Fed Funds and discount rates. These cuts continued until the Discount rate had declined from 6.25% to 2.25% and the Fed Funds rate had declined from 5.25% to 2.00%. All along the way the markets were clamoring for more, faster.
These traditional policy tools weren't working as well as hoped because the fundamental problem in the financial markets was not just a lack of liquidity but fear of not being paid back. Plus, banks were reluctant to borrow at the traditional discount window lest people think they were in trouble. To help overcome that reluctance, and to get money to where it was most needed, the Fed created several special facilities to auction off pre-announced amounts of reserves. Importantly, the FOMC greatly liberalized the terms of that lending – extending the duration of the loans and liberalizing collateral requirements to allow banks use as collateral illiquid securities that weren't trading and which banks needed to unload. Even though the Fed gave the collateral a significant haircut, hopefully their value will return if and when markets normalize. The Fed had waiting time and could be more patient that banks under the circumstances, especially those forced into mark the securities to market, thus reducing capital.
Many large commercial and investment banks reported large losses and write-downs which impaired their capital cushions. This kept the markets nervous and encouraged the hoarding of reserves. The Fed pumped them in but they weren't fully utilized, a phenomenon sometimes called "pushing on a string. The answer to that is more, more.
Early on, Merrill Lynch had two hedge funds fail, and organizations like Merrill, Citigroup, UBS and many others continued to report very large write-downs requiring large capital raises – diluting the capital held by previous share owners as well as depressing financial stock prices.
A potential flashpoint came in March 2008 when customers and counterparties, without apparent reason, suddenly lost confidence in Bear Stearns. Bear had always been more highly leveraged than even other investment banks, but, other than that, the triggering event is not known for sure. Could it have been rumors planted by short sellers? Naked short sellers? I don't know whether it is true or not, but it is plausible that the firm was sound a week before its sudden collapse.
As we all know, no banks, even very sound banks, are liquid enough to withstand a run without an external source of liquidity. However, while commercial banks have deposit insurance that protects them against most runs, investment banks do not. Nor did they have access to the discount window.
As you know, the Fed facilitated the sale of Bear to J.P. Morgan Chase, in part by lending Chase $29 billion on highly illiquid securities. Chase agreed to take the first billion dollars of any losses that occurred. The Fed's role in this was very controversial, as you know, on moral hazard grounds and on general free-market principles against bailouts.
However, just as there are no atheists in fox holes, there probably are no libertarians when they have to deal with a crisis. (I owe that line to Jeffery Frankel of Harvard.) If Bear was not clearly "too big to fail," it was certainly too inter-connected and inter-twined with other financial organizations in the financial system. A sudden closing of Bear would have had great adverse systemic consequences that the Fed, as guardian of the financial system, just couldn't allow to happen.
Two points in defense of my old institution, the Fed: First, it wasn't technically a bailout. The managers and owners and many employees of Bear lost virtually everything. Second, the idea behind moral hazard is not to reward risky behavior lest you encourage more of it in the future. I don't think Bear's risky behavior was rewarded in this case. Future leaders of investment banks are not going to look back at this episode and be encouraged to emulate Bear.
Just after Bear's rescue, the Fed opened its discount window to investment banks, which was probably the watershed event in beginning to overcome the financial crisis. Financial markets began improving very slowly after that March event until interrupted by the recent flare-up about mortgage giants Fannie Mae and Freddie Mac. Of course, the Fed was also criticized for offering to open the discount window to Fannie and Freddie as part of Treasury Secretary Paulson's program to restore confidence in Fannie and Freddie. Nobody liked doing it, but without those preventive measures there was a good chance of investments banks falling like dominoes.
After Bear Stearns, speculation shifted to "whose next" and Lehman Brothers was emerging as the consensus candidate; so I find it ironic that a negative report on Fannie and Freddie from a Lehman analysis helped trigger sudden concerns about their viability. I say sudden concerns because nothing had really changed. People like Alan Greenspan have been arguing and testifying for years that Fannie and Freddie should be "reigned in" to slow or reverse their explosive growth – which has resulted in their participation in about half the mortgages in the United States, with their agency securities, mostly mortgage backed, being held in large quantities by financial institutions all over the world.
The problem was that since they were "government sponsored enterprises" investors assumed their debt was backed by the U.S. government; so they could borrow at low rates, somewhere between the treasury market and the private sector. Those favorable borrowing rates allowed virtually unlimited growth potential and their "sponsorship" by the government presumably made sufficient their thin capital cushion and great leverage. That worked until it suddenly didn't. It turned out that even Fannie and Fannie required confidence no matter their balance sheet realities.
This prompted Secretary Paulson to ask for congressional authority to expand the Treasury's $2.5 billion line of credit to Fannie and Freddie by whatever amount might be needed and Mr. Bernanke to offer access to the discount window, if needed. The reasoning is that the open-ended nature of these back stops will reduce the chances they will be needed. I hope that is the case because, with all their flaws, we need Fannie and Freddie to help us out of the mortgage mess. Now is not the time to hobble them. We need them, including their cheap access to capital.
As for the "real" economy, it looks like we won't have the two consecutive months of negative real GDP that is the popular rule of thumb for a recession. Real GDP in the 4th quarter 2007 was plus 0.6 percent, but would have been plus 2.4 percent without the drag of inventory depletion. The 1st quarter for 2008 is now estimated at a growth rate of plus 1.0 percent, but only after benefiting from a partial inventory rebound. A consensus is developing that the 2nd quarter, ended in June, will be 2.0 percent or more. One caution: benchmark revisions in the past three years of GDP numbers will take place on July 31. Some of our small positive quarters could be revised away.
The business cycle dating committee of the National Bureau of Economic Research, however, isn't bound by the two-quarter rule of thumb, and there is better than a 50-50 chance that they will eventually declare a recession, most likely beginning last December. However it comes out, it is remarkable that the economy is still showing positive overall growth give the depth of the housing and mortgage bust.
While our attention has rightly been on the financial crisis and the weakening economy, inflation has risen and the dollar has weakened somewhat more. The Consumer Price Index was up 5 percent in June from a year ago. The Core CPI that excludes food and energy was up a more modest 2.4 percent, but that also is too high.
The recent growth in GDP has been based on productivity growth (output per hour) rather than employment growth. Payroll employment has declined by an average 92,000 jobs per month for the past six months. This Friday, we'll probably learn of another decline in July. The unemployment rate is currently 5.5 percent and is likely to drift higher. A 5 percent inflation rate added to a 5.5 percent unemployment rate has put the "misery index" into double digits, at 10.5 percent. That's low only by ‘70s standards.
The most important thing needed for a return to economic health is for housing prices to bottom out and for home sales to start rising again. That isn't likely real soon even if financial markets improve markedly (to use a Greenspan word), but financial markets are still suffering even after all the Fed has done to liquefy it and open up the bottle necks. I believe mortgage rates are higher now than they were before Fed easing began a year ago.
Looking ahead, the greatest danger could be the election on November 4th. The likely winner, and the party more likely to expand its numbers in Congress, have both vowed to let the Bush tax rate cuts expire. Taxes on regular income don't expire until 2010, although they can be changed by legislation any time. Taxes on capital – on capital gains and dividends – expire after this year. Ironically, wages and the standard of living of "working people" depend greatly on how capital is taxed, since the demand for labor and wages grow with the capital stock. Taxing capital reduces its accumulation and slows the growth in labor income.
The long shot candidate for president has promised to keep the Bush tax-rate cuts in place and to cut the corporate tax rate from 35 percent, which is the second highest in the world, to 25 percent. Both, however, would need the acquiescence of a more liberal Congress.
I don't know to what extent this bad news is already priced into the stock market – probably most, but not all. However, unlikely things can happen. John Kennedy pushed for the largest marginal rate tax cut in our history, and Richard Nixon went to China.