Monday, October 15, 2007

Bernanke on Recent Financial Turmoil

by Bill McBride on 10/15/2007 07:04:00 PM

From Fed Chairman Ben Bernanke: The Recent Financial Turmoil and its Economic and Policy Consequences. A few excerpts:

... despite a few encouraging signs, conditions in mortgage markets remain difficult. The markets for securitized nonprime (that is, subprime and so-called alt-A) loans are showing little activity, securitizations of prime jumbo mortgages reportedly have increased only slightly from low levels, and the spread between the interest rates on nonconforming and conforming mortgages remains elevated. These continued problems suggest that investors will need more time to gather information and reevaluate risks before they are willing to reenter these markets.
Since the September meeting, the incoming data have borne out the Committee's expectations of further weakening in the housing market, as sales have fallen further and new residential construction has continued to decline rapidly. The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year. However, it remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions. We will be following indicators of household and business spending closely as we update our outlook for near-term growth. The evolution of employment and labor income also will bear watching, as gains in real income support consumer spending even if the weakness in house prices adversely affects homeowners' equity. The labor market has shown some signs of cooling, but these are quite tentative so far, and real income is still growing at a solid pace.

On the inflation side, prices of crude oil and other commodities have increased somewhat in recent weeks, and the foreign exchange value of the dollar has weakened. However, overall, the limited data that we have received since the September FOMC meeting are consistent with continued moderate increases in consumer prices. As the Committee noted in its post-meeting statement, we will continue to monitor inflation developments carefully.

It does seem that, together with our earlier actions to enhance liquidity, the September policy action has served to reduce some of the pressure in financial markets, although considerable strains remain. From the perspective of the near-term economic outlook, the improved functioning of financial markets is a positive development in that it increases the likelihood of achieving moderate growth with price stability. However, in such situations, one must also take seriously the possibility that policy actions that have the effect of reducing stress in financial markets may also promote excessive risk-taking and thus increase the probability of future crises. As I indicated in earlier remarks, it is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy. In particular, as I have emphasized, the Federal Reserve has a mandate from the Congress to promote maximum employment and stable prices, and its monetary policy actions will be chosen so as to best meet that mandate.

Indeed, although the Federal Reserve can seek to provide a more stable economic background that will benefit both investors and non-investors, the truth is that it can hardly insulate investors from risk, even if it wished to do so. Developments over the past few months reinforce this point. Those who made bad investment decisions lost money. In particular, investors in subprime mortgages have sustained significant losses, and many of the mortgage companies that made those loans have failed. Moreover, market participants are learning and adjusting--for example, by insisting on better mortgage underwriting and by performing better due diligence on structured credit products. Rather than becoming more crisis-prone, the financial system is likely to emerge from this episode healthier and more stable than before.