by Calculated Risk on 10/13/2010 09:42:00 PM

Here is a different view ...

From Richmond Fed President Jeffrey Lacker: Economic Outlook, October 2010

[I]nflation is now on target, as far as I'm concerned. Over the last 12 months the price index for personal consumption expenditure has risen 1.5 percent, which is exactly what I've been recommending for the last six years. We also track a core price index that omits volatile food and energy prices, and it is sending the same message, having risen by 1.4 percent over the last 12 months. I believe that the Fed's best contribution to our nation's economic prosperity over time would be to keep inflation stable near the current 1.5 percent rate. But inflation has been lower this year, with overall inflation increasing at only a 0.7 percent annual rate, which is too low for me. I would point out that these inflation numbers often run hot or cold for several months at a time, which is why economists focus on the 12-month number I cited a moment ago. I am not yet convinced that inflation is likely to remain undesirably low. Moreover, the public's expectation of future inflation is not at such a low level; indeed, the latest survey from the University of Michigan puts the public's short-run inflation expectation at 2.2 percent. So I do not see a material risk of deflation — that is, an outright decline in the price level.

Lacker speech is a little strange because he mentions three possible reasons for the high unemployment rate - skills mismatch, extended benefits, uncertainty regarding government policies - and leaves out the most widely accepted reason: lack of aggregate demand. Weird.

And on inflation, core CPI (from the BLS) is up 1.0% over the last 12 months and median CPI from the Cleveland Fed (an alternative measure of inflation) is up only 0.5% over the last year - so I'd argue inflation is below Lacker's target.

Lacker is not currently on the FOMC.

by Calculated Risk on 8/27/2010 10:02:00 AM

From Fed Chairman Ben Bernanke: The Economic Outlook and Monetary Policy. Excerpt on monetary policy:

Policy Options for Further Easing
...
I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee's communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists--namely, that the FOMC increase its inflation goals.

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities. ...

A second policy option for the FOMC would be to ease financial conditions through its communication, for example, by modifying its post-meeting statement. ...

A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System. Inside the Fed this rate is known as the IOER rate, the "interest on excess reserves" rate. The IOER rate, currently set at 25 basis points, could be reduced to, say, 10 basis points or even to zero. ...

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC.

Paving the way for QE2.

Update: Bernanke also addressed WHEN the FOMC will act:

Each of the tools that the FOMC has available to provide further policy accommodation--including longer-term securities asset purchases, changes in communication, and reducing the IOER rate--has benefits and drawbacks, which must be appropriately balanced. Under what conditions would the FOMC make further use of these or related policy tools? At this juncture, the Committee has not agreed on specific criteria or triggers for further action, but I can make two general observations.

First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.

by Calculated Risk on 5/22/2010 09:01:00 AM

From NY Fed President William Dudley's commencement speech at New College of Florida:

[T]he recovery is not likely to be as robust as we would like for several reasons.

First, households are still in the process of deleveraging. The housing boom created paper wealth that households borrowed against. This pushed the consumption share of nominal gross domestic product to a record high of about 70 percent. When the boom turned into a bust, those paper gains evaporated. In fact, many households now find that the value of their homes is less than the amount of their mortgage debt. This has created a difficult time for many families and has caused the hangover to last longer.

Second, the banking system is still under significant stress. This is particularly the case for small- and medium-sized banks that have significant exposure to commercial real estate loans. This stress means that banks have been slow to ease credit standards as the economy has moved from recession to recovery.

Third, some of the sources that have supported the nascent recovery are temporary. The big swing from inventory liquidation during the recession back to accumulation will soon end as inventory levels come back into better balance with sales. And fiscal stimulus from the federal government is subsiding and will soon reverse.
...
In this environment, finding a job will be tough, but when you hit the pavement remember that the job market is improving. Don't get discouraged.

A few comments:

First, the household "deleveraging" seemed to start last year, but consumers were back to spending more than they earned in Q1. Personal consumption expenditures (PCE) increased to over 71% of GDP in Q1 - higher than the 70% during the boom that Dudley mentioned. Some of this increase in PCE was due to government transfer payments (all of the increase in income in Q1 came from government transfer payments). I still think the personal saving rate will rise over the next year or two - and that will keep growth in PCE below the growth in income.

Second, I think the transitory inventory boost is about over. There were hints of this in the manufacturing surveys last week from the Federal Reserve Banks of Philadelphia and New York - and also in the Census Bureau's Manufacturing and Trade inventories report for March. Also, as Dudley notes, the boost from the stimulus "is subsiding and will soon reverse" (the peak stimulus spending is right now - in Q2 2010).

These are significant headwinds, and I think growth will slow in the 2nd half of 2010.

by Calculated Risk on 5/18/2010 12:45:00 PM

From Cleveland Fed President Sandra Pianalto: Forecasting in Uncertain Times

As we are all aware, we're emerging from the deepest and longest recession since the Great Depression. Our models would tell us that the deeper the downturn in the economy, the more rapid the recovery. You've probably heard this referred to as a V-shaped recovery.

However, my outlook is that our journey out of this deep recession will be a slow one because we face two primary headwinds that I expect will temper growth for awhile. The first is the effect of prolonged unemployment, and the second is a heightened sense of caution on the part of consumers and businesspeople.
...
About half of those who are currently unemployed have been out of work for at least six months, and the longer someone is out of work, the harder it is to find a job. In the 1982 recession, which was another severe recession, the average duration of unemployment peaked at 21 weeks, but today the average is already over 30 weeks—a record high. Research also tells us that workers lose valuable skills during long spells of unemployment, and that some jobs simply don't return.
...
The second powerful headwind in this recession is a heightened sense of caution, driven by a deep uncertainty about where the "new normal" or baseline might be. A whole generation of Americans who began their working careers in the mid-1980s had experienced only long periods of prosperity punctuated by just two very brief downturns. Those experiences encouraged an expectation for relatively smooth growth. Now everyone's expectations have shifted as a result of this long and deep recession.

People's attitudes about their own prospects have fundamentally changed. In a recent survey by Ohio's Xavier University, 60 percent of those polled believe attaining the American dream is harder for this generation than ones before. And nearly 70 percent think it will be even more difficult for their children. Many people are now just aiming for “financial security” as their American dream
...
Businesses are also cautious. Business leaders base many decisions on forecasts, and they tell me that they are attaching the same high degree of uncertainty around their projections as I am. Most business leaders say that they’re not planning significant hiring until there’s more clarity about how the recovery is going to progress and about policies relating to health care, energy, the environment, and taxes. This caution translates into fewer job opportunities, fewer equipment purchases, fewer building projects—and on and on.

These two factors—overall caution and the effects of labor market damage—lead me to an outlook for relatively subdued output growth through this year and next, with unemployment rates that decline only gradually.

We already know that a "V-shaped" recovery is off the table. Researchers at the San Francisco Fed argued yesterday for a recovery between a "U" and a "V", see The Shape of Things to Come, however those researchers focused on GDP, and I'd suggest GDI, employment and real personal income less transfer payments all suggest an even more sluggish recovery than GDP.

Also I'd add residential investment to Pianalto's two "headwinds". Usually housing is a key engine of growth in a recovery - for both GDP and employment - and this time any contribution from housing will be muted for some time.

by Calculated Risk on 3/03/2010 01:02:00 PM

From Altanta Fed President Dennis Lockhart: Recovery and Reform Excerpts:

My current forecast—and that of my staff at the Federal Reserve Bank of Atlanta—lines up with ... the modest recovery scenario.

The incoming data through last week have not made me alter my basic forecast, but I consider it still too early to make a definitive call on which scenario will play out. The January numbers, as you may know, have been mixed. Consumer spending was strong for the month, while business spending on capital goods was weak, and job growth was flat. Upside surprises in inventories, capital spending, and consumption could tip the scales in favor of a stronger growth forecast. I will be particularly attentive, watching for evidence of these developments as the recovery proceeds.

Because I hold to this forecast of modest recovery and believe inflation is likely to remain subdued, I fully support the message of the most recent FOMC statement to the effect that the fed funds target rate will remain exceptionally low for an extended period.

This is a follow-up to Lockhart's The Economic Outlook: A Tale of Two Narratives.

I still expect the recovery to be sluggish and choppy in 2010, but for the economy to avoid a "double dip" recession.

by Calculated Risk on 2/25/2010 09:15:00 AM

From Cleveland Fed President Sandra Pianalto: When the Small Stuff Is Anything But Small. A few excerpts:

You know we have been through one of the most severe and longest recessions in our nation’s history. The recovery from the recession may also end up being one of the longest in our history. In fact, it may take years just to get back to the level of output we enjoyed in 2007, just before the economic crisis began.

Some of you may think I am being too pessimistic. After all, we saw a strong GDP growth estimate for the fourth quarter of last year--nearly 6 percent at an annual rate. But I think that figure overstates the underlying strength of our economy right now.

This is a case where paying attention to the small stuff--the details beneath that impressive number--reveals a more complicated story of what is shaping up to be a gradual recovery. Most of the thrust behind that impressive fourth-quarter GDP growth figure owes to a rebuilding of inventory stocks, which had been cut to the bone and could no longer support even a mild economic recovery. Over the course of this year, I expect overall growth in employment and output to be on the weak side for the early stages of an economic recovery.

For many American households and businesses, this is a recovery that just does not feel much like a recovery. Let me point to two reasons why this is so. The first is due to the large amount of excess capacity that has accumulated. As spending declined in the recession, firms of all sizes cut back, drastically in many cases.
...
Excess capacity is a dilemma for businesses of all sizes. They can maintain capacity for only so long without an uptick in sales, and they’re confronting a market where demand is only gradually recovering after having fallen off a cliff. In fact, according to the most recent survey of the National Federation of Independent Business, or NFIB (January 2010), members cited poor sales as their single most important problem. The latest American Express Open Pulse Survey also expresses a similar perspective. A very slow recovery in demand, which translates into low sales for most firms, makes it far tougher to maintain idle capacity over time. ...

One of the forces holding back demand is the continuing high level of unemployment. Indeed, poor labor market conditions pose another large challenge to the recovery. ...

The duration of unemployment is also a big concern. According to the Bureau of Labor Statistics, the share of workers who have been without jobs for 27 weeks or longer now stands at 41 percent--the highest number since this series began in 1948.

Clearly, massive layoffs contributed to these large unemployment numbers, and fortunately, layoffs slowed months ago. Our current problem is a lack of job openings. In fact, the job-finding rate now stands at a historic low. Businesses are not creating new jobs very quickly, and where labor utilization is picking up, employers are simply restoring hours that had been previously cut.
...
So, to sum up, while we are likely now in a period of recovery, it doesn't really feel much like one. All types of businesses are continuing to see weak levels of demand – in other words, they don't expect to see a bounce-back in sales for quite a while yet. This in turn creates excess capacity, which leaves businesses having to decide whether to maintain or shut idle plants and offices. In such an environment, firms are being cautious about new hiring and so unemployment persists at a high level, which in turn restrains spending. From any perspective this is not a pretty picture, but it is especially challenging for small business ...

Some of these bloggers Fed Presidents are pretty pessimistic!

by Calculated Risk on 2/22/2010 11:04:00 AM

From San Francisco Fed President Janet Yellen: The Outlook for the Economy and Monetary Policy. Excerpts:

... I’m not at all convinced that a V-shaped recovery is in the cards. That fourth-quarter leap in GDP overstates the underlying momentum of the economy. Much of it was due to a slowdown in the pace at which businesses were drawing down inventory stocks compared with earlier in the year. Less than half of the fourth-quarter growth reflected higher sales to customers. Those sales did grow, but at a lackluster 2.2 percent. It appears that businesses are getting their inventories closer in line with sales, which is a good thing. But such inventory adjustments can be a potent source of growth only for a few quarters. I’d feel much more confident about the prospect for a sustained robust recovery if I saw evidence of more vigorous growth in actual sales.

... my business contacts tell me the consumer mindset is still in a fragile state. Clearly, the big weight hanging over everyone’s heads is jobs. ...

The housing sector appears to have stabilized, but here too I don’t see any signs of a sharp turnaround. New home sales and construction finally stopped falling last year and have been reasonably stable, albeit at very low levels, for several months. Existing home sales surged late last year in response to the homebuyer tax credit. But, the credit expires this spring, so this source of support won’t be around much longer. The housing sector has also been benefiting from the Fed’s policy of buying mortgage-backed securities. These purchases appear to have helped keep home finance rates low. But, the Fed is now in the process of tapering off these purchases and plans to stop them at the end of March. As support from Federal Reserve and other government programs phases out, there is a risk that the housing market could weaken again.
...
Put it all together and you have a recipe for a moderate rate of economic growth, well below the spritely pace set in the fourth quarter. The current quarter appears on course to post growth of around 3 percent. I see the economy gradually picking up steam over the remainder of this year as households and businesses regain confidence, financial conditions improve, and banks increase the supply of credit. I expect growth of about 3½ percent for the year as a whole, picking up to about 4½ percent next year, with private demand coming on line to pick up the slack as government stimulus programs fade away.
...
This brings us to a subject that is of paramount concern to all of us—the job situation. This recession has been very severe, indeed. The U.S. economy has shed 8.4 million jobs since December 2007. That’s more than a 6 percent drop in payrolls, the largest percentage point decline since the demobilization following World War II. The unemployment rate, which was 5 percent at the start of the recession, rose to around 10 percent in late 2009. The rates of job openings and hiring are also stuck at very low levels. These statistics represent a tragedy for our country, our communities, and each of the families and individuals who have had to cope with a loss of livelihood.

There is a glimmer of good news on the employment front. The pace of job losses has slowed dramatically and some indicators, such as gains in temporary jobs, suggest that we may be close to a turnaround in the labor market. I was encouraged to see the unemployment rate drop from 10 percent to 9.7 percent in January. Nonetheless, given my forecast of moderate growth and a shrinking, but still sizable, output gap, I expect unemployment to remain painfully high for years. The rate should edge down from its current level to about 9¼ percent by the end of this year and still be about 8 percent by the end of 2011, a far cry from full employment.

I should warn that there is a great deal of uncertainty surrounding this forecast.

There is much more in the speech. Dr. Yellen's outlook is a little more optimistic than me (I think growth will be more sluggish in 2010).

by Calculated Risk on 2/18/2010 07:20:00 PM

First, Alanta Fed President Dennis Lockhart commented on the increase in the discount rate:

How should today's announcement be interpreted? I would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent. Rather, this action should be viewed as a normalization step.
...
[T]he public and markets should not misinterpret today's move. Monetary policy—as evidenced by the fed funds rate target—remains accommodative. This stance is necessary to support a recovery that is in an early stage and, in my view, still fragile.
emphasis added

See his speech for more explanation and details.

And on the economic outlook:

I see two competing narratives about how this recovery will play out. Growth in the fourth quarter of 2009 was quite strong and raises hope for a robust recovery. In this, the first narrative—that of a traditional sharp bounce-back following a deep recession—growth exceeds the underlying long-term potential of the economy and unemployment declines at an accelerating pace.

In this narrative, businesses rebuild inventory levels and resume capital expenditures in anticipation of growing sales. Consumers regain confidence, and retail spending grows briskly. You can add positive export growth as the economies of our major trading partners—especially in Asia—also show better growth.

Finally, in this narrative the banking system successfully navigates a weak commercial real estate sector and starts expanding credit to both business and consumers.

The alternative narrative entails some fundamental changes in business practices and consumer habits. In this scenario, businesses have learned from the recession that they can operate permanently at leaner inventory levels and flat or lower employee head counts. And the impressive worker productivity gains measured in recent data continue to accumulate.

Consumers, in this narrative, have assumed a quite different mind-set compared to the precrisis, prerecession "normal." Chastened by the recession and high unemployment—consumers are simply more frugal and more inclined to save. And even if consumers wanted to resume prerecession spending habits, the consumer finance industry, in this narrative, will not accommodate previous levels of consumption.

In this narrative, growth continues, but at a very modest pace, and unemployment is very slow to recede. The first narrative is a return to something resembling normal as we knew it; the second narrative describes a somewhat new and different world.
...
My team of Atlanta Fed economists and I are forecasting the second narrative.

There is probably a third narrative too with the economy sliding back into recession.

I'm in the "second narrative" group, and I think growth will be sluggish in 2010 primarily because of the overhang of excess housing inventory (slowing any recovery in residential investment), and because consumers will increase their saving rate to repair their household balance sheets.

by Calculated Risk on 2/10/2010 10:01:00 AM

Fed Chairman Ben Bernanke's prepared statement: Federal Reserve's exit strategy. In this testimony, Bernanke outlines the steps to unwind monetary stimulus. An excerpt:

I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery. However, to help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid. The Federal Reserve is currently rolling over all maturing Treasury securities, but in the future it may choose not to do so in all cases. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities. Although passively redeeming agency debt and MBS as they mature or are prepaid will move us in that direction, the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted. Any such sales would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions.

As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn. The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.

A few points:

It is unlikely that the Fed will raise the Fed Funds rate any time soon (very unlikely this year, and maybe not in 2011).

However the Fed might use an alternative short term interest rate - such as interest rate paid on reserves - to communicate policy.

The Fed will not sell MBS "in the near term", but is allowing agency debt and MBS to run off.

by Calculated Risk on 1/11/2010 12:15:00 AM

From Bloomberg: Fed’s Bullard Says Asset-Purchase Adjustments Main Policy Issue (ht MrM)

[St. Louis Fed President] James Bullard said the main challenge for U.S. policy makers will be to adjust the asset-purchase program ...

The Fed should retain flexibility by adopting a “state- contingent” policy that would allow for the adjustment of such purchases as new information becomes available ... He said it was “disappointing” that markets focus more on interest rates instead of the Fed’s quantitative monetary policy.
...
“Markets are still thinking of monetary policy strictly as changes in interest rates even though the Fed has been conducting successful policy this past year through quantitative easing,” Bullard said. “Markets should be focusing on quantitative monetary policy rather than interest rate policy.”

It is pretty clear that the Fed will not raise rates any time soon.

by Calculated Risk on 1/04/2010 01:09:00 PM

From Fed Governor Elizabeth Duke: The Economic Outlook

In my view, the outlook for economic activity depends importantly on our ability to build on the progress to date in improving the operation of financial markets and restoring the flow of credit to households and businesses.

Although household wealth has received a boost from the gains in the stock market over the last nine months and from the stabilization in house prices, household balance sheets remain weak. In 2009, household income received some temporary support from the tax cuts and transfer payments enacted with the fiscal stimulus package and from the extensions of unemployment insurance. Over the coming year, households should begin to see gains in income associated with an improvement in the labor market, and the drag on spending from past declines in real net worth should ease. As their income and balance sheets improve, consumers should have better access to credit. Favorable trends in income and employment should also bolster consumer confidence, although one risk I see to the outlook for household spending is the possibility of a rise in the personal saving rate as consumers choose to shore up their balance sheets rather than spend. While good in the long run, increased saving means consumers are providing less of a short-run boost to the economy.

The outlook for homebuilding will depend critically on the continuation of the uptrend in the demand for housing that began in early 2009. I anticipate that low mortgage rates and house prices that are still very low compared with the recent past will continue to provide important support for demand. And a shift in expectations from falling house prices to modest appreciation should encourage buyers to invest in houses. That said, the headwinds in housing and mortgage markets remain relatively strong and are likely to restrain the pace at which the residential construction sector recovers. Many of the existing homeowners who face payment problems are having trouble restructuring their loans, and the large backlog of foreclosed properties will likely take several years to resolve. Tighter standards for government-backed loans and still-restrictive credit conditions in private loan markets are also likely to slow the housing recovery. Nevertheless, with the inventory of new homes having been worked down to a relatively low level, even a gradual strengthening of demand should lead to an upturn in homebuilding.

Prospects for a recovery in business investment are getting better as we move into 2010. Typically, business confidence builds as firms see a sustained increase in sales and output. Various indicators of business sentiment rebounded over the second half of 2009 as economic activity accelerated, and the latest surveys of capital spending plans have been more positive. That said, the amount of unused capacity in the business sector is substantial, which implies that the recovery in spending on equipment and software will likely be more gradual than typically occurs during a cyclical recovery.
...
Unfortunately, the outlook for commercial real estate is much less favorable. Hit hard by the loss of businesses and employment, a good deal of retail, office, and industrial space is standing vacant. In addition, many businesses have cut expenses by renegotiating existing leases. The combination of reduced cash flows and higher rates of return required by investors leads to lower valuations, and many existing buildings are selling at a loss. As a result, credit conditions in this market are particularly strained. Commercial mortgage delinquency rates have soared. ...

In this environment, a turnaround in CRE is likely to lag the improvement in overall economic activity. However, compared with the situation in the early 1990s, the problems in this sector now appear to be due largely to poor business fundamentals rather than widespread overbuilding, suggesting that the performance of the CRE sector will gradually begin to improve as the economy continues to strengthen.

An important element of a sustained economic recovery will be an improvement in labor market conditions. Employment gains typically lag the recovery in sales and production in the early months of an economic upturn. In many cycles, the lag occurs because businesses need to restore productivity and are reluctant to hire until they are more confident that any pickup in sales will be maintained. In this cycle, the reductions in jobs and hours of work have been so deep, and the pressure to cut costs has been so strong, that businesses in the aggregate have already realized solid gains in productivity. As a result, I expect that businesses will begin to add jobs this year, but I anticipate that they will do so cautiously in order to hang on to their cost savings and efficiency gains.

Even as the unemployment rate begins to decline later this year, it likely will remain high by historical standards. Based on the experience of the last two economic recoveries, net gains of roughly 100,000 payroll jobs each month are needed to reduce the jobless rate by 0.1 percentage point. ...
emphasis added

I think Ms. Duke is somewhat too optimistic on housing and employment. It might take more payroll jobs to lower the unemployment rate this time because the Labor Force Participation Rate has declined so sharply; the BLS reported the participation rate as 65.0% in November (the percentage of the working age population in the labor force). This is the lowest level since the mid-80s, and I expect a number of people will rejoin the labor force at the first sign of an employment recovery, putting upward pressure on the unemployment rate.

by Calculated Risk on 12/07/2009 06:35:00 PM

From NY Fed President William Dudley: Still More Lessons from the Crisis

The entire speech is worth reading. Dudley discusses a number of topics including his economic outlook, how the Fed should respond to bubbles, and why he believes the Fed should retain supervisory authority.

Dudley offers a mea culpa for the Fed:

With the benefit of hindsight, it is clear that the Fed and other regulators, both here and abroad, did not sufficiently understand some of the critical vulnerabilities in the financial system, including the consequences of inappropriate incentives, and the opacity and the large number of self-amplifying mechanisms that were embedded within the system. Likewise, we did not appreciate all the ramifications of the growth of the shadow banking system and its linkage back to regulated financial institutions until after the crisis began.

It didn't take "hindsight" to see that the Fed was failing to properly regulate the financial system - many people were pointing out the problems in real time, and the Fed simply chose to ignore the warnings.

On bubbles:

[I]dentifying asset bubbles in real time is difficult. However, identifying variables that often are associated with asset bubbles—especially credit asset bubbles—may be less daunting. To take one recent example, there was a tremendous increase in financial leverage in the U.S. financial system over the period from 2003 to 2007, particularly in the nonbank financial sector. This sharp rise in leverage was observable. Presumably, this rise in leverage also raised the risks of a financial asset bubble and the impact of this bubble on housing certainly raised the stakes for the real economy if such a bubble were to burst. This suggests that limiting the overall increase in leverage throughout the system could have reduced the risk of a bubble and the consequences if the bubble were to burst.

Turning to ... how to limit and/or deflate bubbles in an orderly fashion, the fact that increases in leverage are often associated with financial asset bubbles suggests that limiting increases in leverage may help to prevent bubbles from being created in the first place. This again suggests that there is a role for supervision and regulation in the bubble prevention process. ...

Whether there is a role for monetary policy to limit asset bubbles is a more difficult question. On the one hand, monetary policy is a blunt tool for use in preventing bubbles because monetary policy actions also have important consequences for real economic activity, employment and inflation. On the other hand, however, there is evidence that monetary policy does have an impact on desired leverage through its impact on the shape of the yield curve. A tighter monetary policy, by flattening the yield curve, may limit the buildup in leverage.
emphasis added

We are making progress on bubbles.

And on the economic outlook:

My views about the outlook have not changed much recently and do not differ much from the consensus. The situation is slowly improving. We are having a recovery in terms of output and the pace of job losses has slowed substantially. In the second half of this year, real GDP growth will likely fall in a 3 percent to 3.5 percent annualized range. 2010 will probably be slightly weaker than that, mostly because some of the current sources of strength are temporary. The inventory cycle is providing lots of support right now and the fiscal stimulus—which is very powerful right now — will abate as we go through 2010.

2010 is also likely to be a more moderate growth period because we still face quite a few headwinds generated by the hangover of the financial crisis. ...

If growth is subdued, this implies that the unemployment rate will stay high and inflation will stay low. If this outlook is broadly correct, this suggests that it will be appropriate to keep the federal funds rate target exceptionally low for an extended period.

It is very unlikely that the Fed will raise the Fed funds rate in 2010.

by Calculated Risk on 12/07/2009 12:45:00 PM

From Fed Chairman Ben Bernanke: Frequently Asked Questions. Dr. Bernanke discusses four questions:

1. Where is the economy headed?
2. What has the Federal Reserve been doing to support the economy and the financial system?
3. Will the Federal Reserve's actions lead to higher inflation down the road?
4. How can we avoid a similar crisis in the future?

On inflation, Bernanke says he expects "inflation to remain subdued for some time." On the economy:

Where Is the Economy Headed?
... Recently we have seen some pickup in economic activity, reflecting, in part, the waning of some forces that had been restraining the economy during the preceding several quarters. The collapse of final demand that accelerated in the latter part of 2008 left many firms with excessive inventories of unsold goods, which in turn led them to cut production and employment aggressively. This phenomenon was especially evident in the motor vehicle industry, where automakers, a number of whom were facing severe financial pressures, temporarily suspended production at many plants. By the middle of this year, however, inventories had been sufficiently reduced to encourage firms in a wide range of industries to begin increasing output again, contributing to the recent upturn in the nation's gross domestic product (GDP).

Although the working down of inventories has encouraged production, a sustainable recovery requires renewed growth in final sales. It is encouraging that we have begun to see some evidence of stronger demand for homes and consumer goods and services. In the housing sector, sales of new and existing homes have moved up appreciably over the course of this year, and prices have firmed a bit. Meanwhile, the inventory of unsold new homes has been shrinking. Reflecting these developments, homebuilders have somewhat increased the rate of new construction--a marked change from the steep declines that have characterized the past few years.

Consumer spending also has been rising since midyear. Part of this increase reflected a temporary surge in auto purchases that resulted from the "cash for clunkers" program, but spending in categories other than motor vehicles has increased as well. In the business sector, outlays for new equipment and software are showing tentative signs of stabilizing, and improving economic conditions abroad have buoyed the demand for U.S. exports.

Though we have begun to see some improvement in economic activity, we still have some way to go before we can be assured that the recovery will be self-sustaining. Also at issue is whether the recovery will be strong enough to create the large number of jobs that will be needed to materially bring down the unemployment rate. Economic forecasts are subject to great uncertainty, but my best guess at this point is that we will continue to see modest economic growth next year--sufficient to bring down the unemployment rate, but at a pace slower than we would like.

A number of factors support the view that the recovery will continue next year. Importantly, financial conditions continue to improve: Corporations are having relatively little difficulty raising funds in the bond and stock markets, stock prices and other asset values have recovered significantly from their lows, and a variety of indicators suggest that fears of systemic collapse have receded substantially. Monetary and fiscal policies are supportive. And I have already mentioned what appear to be improving conditions in housing, consumer expenditure, business investment, and global economic activity.

On the other hand, the economy confronts some formidable headwinds that seem likely to keep the pace of expansion moderate. Despite the general improvement in financial conditions, credit remains tight for many borrowers, particularly bank-dependent borrowers such as households and small businesses. And the job market, though no longer contracting at the pace we saw in 2008 and earlier this year, remains weak. Household spending is unlikely to grow rapidly when people remain worried about job security and have limited access to credit.

Inflation is affected by a number of crosscurrents. High rates of resource slack are contributing to a slowing in underlying wage and price trends, and longer-run inflation expectations are stable. Commodities prices have risen lately, likely reflecting the pickup in global economic activity and the depreciation of the dollar. Although we will continue to monitor inflation closely, on net it appears likely to remain subdued for some time.

by Calculated Risk on 11/22/2009 07:26:00 PM

From the WSJ Real Time Economics: Fed’s Bullard: Asset Buying Efforts Should Remain Active (ht (Bob_in_MA)

“I have advocated to keep the asset purchase program open but at a very low level, and wait and see what happens, and as information comes in about the economy we can adjust that program while the federal funds rate remains at zero,” [Federal Reserve Bank of St. Louis President James] Bullard told Dow Jones Newswires in an interview Sunday ahead of a conference in New York. He added “no decision has been made” about the program’s fate.
...
Citing the current level of the Fed’s overnight interest rate target, Bullard said “as long as we are at zero (percent) we’d be able to send signals to the markets about what we are thinking about the economy, and how much accommodation the economy needs at various points, by adjusting the asset purchases.”

Bullard will be a voting member of the FOMC next year.

Here are the slides from Bullard's speech today. Here are a few excerpts:

KEY PROBLEM: TOO BIG TO FAIL

The crisis showed that large financial institutions worldwide were “too big to fail.” (TBTF)

Really, “too big to fail quickly.”

If we let large financial firms fail suddenly, global panic ensues.

Again, these firms are not necessarily banks.

Reform efforts must focus on getting this intolerable situation under control.

TBTF is very costly to the macroeconomy as well as unfair.

We need laser-like focus on this problem.

ACTUAL PROPOSALS

Proposals addressing TBTF:

Systemic risk regulation: A council with the Fed having implementation responsibility.

A resolution regime for large financial firms.

Split up large firms.

There are important global coordination issues.

Difficulties in design suggests a “go slow” approach.

The crisis will not soon be forgotten.

by Calculated Risk on 11/17/2009 10:46:00 AM

From Richmond Fed President Jeffrey Lacker The Economic Outlook:

Earlier this year some economists were highlighting the risk that the low level of economic activity could push the rate of inflation down, perhaps even below zero. I think the risk of a substantial further reduction in inflation has diminished substantially since then. The historical record suggests that the early years of a recovery is when the risk is greatest that confidence in the stability of inflation erodes and we see an upward drift in inflation and inflation expectations. This risk could be particularly pertinent to the current recovery, given the massive and unprecedented expansion in bank reserves that has occurred, and the widespread market commentary expressing uncertainty over whether the Federal Reserve is willing and able to promptly reverse that expansion.

As a technical matter, I do not see any problem – we do have the tools to remove as much monetary stimulus as necessary to keep inflation low and stable. The harder problem is the same one that we face after every recession, which is choosing when and how rapidly to remove monetary stimulus. There is no doubt that we must be aware of the danger of aborting a weak, uneven recovery if we tighten too soon. But if we hope to keep inflation in check, we cannot be paralyzed by patches of lingering weakness, which could persist well into the recovery. In assessing when we will need to begin taking monetary stimulus out, I will be looking for the time at which economic growth is strong enough and well-enough established, even if it is not yet especially vigorous.

Lacker is one of the inflation hawks on the FOMC.

First, I think we could see further declines in inflation in 2010; even the possibility of core PCI deflation. I don't think the risk of further declines has "diminished substantially".

Second, I think Q3 GDP will be revised down based on subsequent data (like the trade report), and GDP growth will be lower than Lacker expects in early 2010. I think Lacker is overly optimistic on the economy.

Also - historically the Fed hasn't raised rates until well after unemployment peaks, and I doubt they will raise rates until late in 2010 at the earliest (and probably later). Here is a graph from a previous post in September (the unemployment rate is now 10.2%):

Click on graph for larger image in new window.

This graph shows the effective Fed Funds rate (Source: Federal Reserve) and the unemployment rate (source: BLS)

In the early '90s, the Fed waited more than a 1 1/2 years after the unemployment rate peaked before raising rates. The unemployment rate had fallen from 7.8% to 6.6% before the Fed raised rates.

Following the peak unemployment rate in 2003 of 6.3%, the Fed waited a year to raise rates. The unemployment rate had fallen to 5.6% in June 2004 before the Fed raised rates.

by Calculated Risk on 11/16/2009 12:15:00 PM

Here is a live video of Bernanke at the Economic Club of NY

Here is the CNBC feed.

Prepared Speech: On the Outlook for the Economy and Policy

How the economy will evolve in 2010 and beyond is less certain. On the one hand, those who see further weakness or even a relapse into recession next year point out that some of the sources of the recent pickup--including a reduced pace of inventory liquidation and limited-time policies such as the "cash for clunkers" program--are likely to provide only temporary support to the economy. On the other hand, those who are more optimistic point to indications of more fundamental improvements, including strengthening consumer spending outside of autos, a nascent recovery in home construction, continued stabilization in financial conditions, and stronger growth abroad.

My own view is that the recent pickup reflects more than purely temporary factors and that continued growth next year is likely. However, some important headwinds--in particular, constrained bank lending and a weak job market--likely will prevent the expansion from being as robust as we would hope.

On CRE (added):

Demand for commercial property has dropped as the economy has weakened, leading to significant declines in property values, increased vacancy rates, and falling rents. These poor fundamentals have caused a sharp deterioration in the credit quality of CRE loans on banks' books and of the loans that back commercial mortgage-backed securities (CMBS). Pressures may be particularly acute at smaller regional and community banks that entered the crisis with high concentrations of CRE loans. In response, banks have been reducing their exposure to these loans quite rapidly in recent months. Meanwhile, the market for securitizations backed by these loans remains all but closed. With nearly $500 billion of CRE loans scheduled to mature annually over the next few years, the performance of this sector depends critically on the ability of borrowers to refinance many of those loans. Especially if CMBS financing remains unavailable, banks will face the tough decision of whether to roll over maturing debt or to foreclose.

More:

I expect moderate economic growth to continue next year. Final demand shows signs of strengthening, supported by the broad improvement in financial conditions. Additionally, the beneficial influence of the inventory cycle on production should continue for somewhat longer. Housing faces important problems, including continuing high foreclosure rates, but residential investment should become a small positive for growth next year rather than a significant drag, as has been the case for the past several years. Prospects for nonresidential construction are poor, however, given weak fundamentals and tight financing conditions.
...
Jobs are likely to remain scarce for some time, keeping households cautious about spending. As the recovery becomes established, however, payrolls should begin to grow again, at a pace that increases over time. Nevertheless, as net gains of roughly 100,000 jobs per month are needed just to absorb new entrants to the labor force, the unemployment rate likely will decline only slowly if economic growth remains moderate, as I expect.

by Calculated Risk on 11/10/2009 07:39:00 PM

"[L]ooking into 2010 and perhaps to 2011, the most likely outcome is for growth to be suboptimal, unemployment to remain a vexing problem and inflation to remain subdued."
Dallas Fed President Richard Fisher

And a little more Fed Speak ... (note: Fisher's speeches are always colorful).

From Dallas Fed President Richard Fisher: The Current State of the Economy and a Look to the Future

Now, I’ve often thought that economic forecasters seem to be cursed—or maybe blessed, I suppose, dependent upon your point-of-view—with a short-term memory: They tend to extrapolate only the most recent trends into the future. As if goosed by the more optimistic tone of the latest GDP release, many now believe that solid output growth will extend into the first half of next year. The latest Blue Chip survey, for example, shows that professional forecasters expect GDP growth averaging 2.8 percent in the first half of 2010.

I am wary of the consensus view. For a good while now, I’ve suggested that we are more likely to see a more uneven recovery—not a “V”-shaped recovery but something more akin to a check mark, where the elongated arm of that check mark inclines at a slope that is less than desirable and might possibly be repressed by an occasional pause or several quarters of weak growth.

Why a check mark?

Several recent sources of strength are likely to wane as we head into next year. Cash-for-clunkers and the first-time-homebuyer tax credit have both shifted demand forward, increasing sales today at the expense of sales tomorrow. Neither of these programs can be repeated with any real hope of achieving anywhere near the same effect: The more demand you steal from the future, the less future demand there is for you to steal. The general tax cuts and government spending increases included in this year’s fiscal stimulus package won’t have their peak impact on the level of GDP until sometime in 2010, but their peak impact on the growth of GDP has come and gone; the fiscal stimulus continues to drive GDP upward, compared with what it would otherwise have been, but the increments to GDP are beginning to shrink. And, as we all know, the shot in the arm that our economy is receiving from inventory adjustments is, while welcome, inherently transitory.

What about growth in the longer term—the second half of 2010 and beyond? American households have finally come to realize that they’ve been playing the part of the grasshopper in Aesop’s fable: They see that our previous spending boom was financed by somewhat reckless disregard for tomorrow by over-eager creditors feeding their desire for unsustainable leveraging of their income and balance sheets and, for the nation as a whole, by increases in overseas borrowing. That reality has been largely absorbed, and consumer spending is growing again—albeit from a lower base and at a slower pace. I doubt it will recover its previous vigor for some time to come. I expect that the strong bounce-back in consumer demand that we’ve come to expect in recoveries past will be absent this time around as Americans recalibrate the proportion of their income and wealth that they need to save versus what they need to consume. We need not become a nation as parsimonious as William Miles, but we are going to have to be more ant- than grasshopper-like in our behavior.[4]
...
It may be some time before significant job growth occurs and even longer before we see meaningful declines in the unemployment rate.
emphasis added

And Fisher is usually one of the more optimistic Fed presidents.

by Calculated Risk on 11/10/2009 09:23:00 AM

From Atlanta Fed President Dennis Lockhart: Economic Recovery, Small Business, and the Challenge of Commercial Real Estate

[H]ow serious is the CRE problem for the financial system and the broad economy?

First, let me provide some overview comments: While the CRE problem is serious for parts of the banking industry, I don't believe it poses a broad risk to the financial system. Compared with residential real estate, the size of the CRE debt market is smaller, and the exposure is more concentrated in smaller banks.

However, I am concerned about the potential impact of CRE on the broader economy. Unlike residential real estate, there is not the same direct linkage from CRE to household wealth—and therefore consumption—caused by erosion of home equity. However, there could be an impact resulting from small banks' impaired ability to support the small business sector—a sector I expect will be critically important to job creation.

To add some detail: At the end of June 2009 there was approximately $3.5 trillion of outstanding debt associated with CRE. This figure compares with about $11 trillion of residential debt outstanding.

About 40 percent of the CRE debt is held on commercial bank balance sheets in the form of whole loans. A lot of the CRE exposure is concentrated at smaller institutions (banks with total assets under $10 billion). These smaller banks account for only 20 percent of total commercial banking assets in the United States but carry almost half of total CRE loans (based on Bank Call Report data).

Many small businesses rely on these smaller banks for credit. Small banks account for almost half of all small business loans (loans under $1 million). Moreover, small firms' reliance on banks with heavy CRE exposure is substantial. Banks with the highest CRE exposure (CRE loan books that are more than three times their tier 1 capital) account for almost 40 percent of all small business loans.

To repeat my current assessment, while the CRE problem is very worrisome for parts of the banking industry, I don't see it posing a broad risk to the financial system. Nonetheless, CRE could be a factor that suppresses the pace of recovery. As the recovery develops, the CRE problem will be a headwind, but not a show stopper, in my view.

It's appropriate to be a bit tentative in the assessment of CRE risk to the financial system, however. In 2007, many underestimated the scale and contagion potential of the subprime residential mortgage-backed securities problem. With this experience in mind, my assessment should continue to be refined.

As Lockhart noted earlier in the speech, small business employment has been especially hard hit during the current employment recession. (Note: this is probably one of the key reasons that the BLS birth/death model has overestimated new job creation).

Many of the banks in trouble because of CRE lending are also key lenders to small businesses. Therefore this might limit small business financing, and further inhibit small business job creation.

by Calculated Risk on 11/09/2009 08:39:00 AM

St. Louis Fed President James Bullard told the Financial Times that uncertainty about the inflation outlook is the most since 1980.

From the Financial Times: Uncertainty ‘high’ over inflation outlook

“For 2009, in particular, and maybe a little bit into 2010, you have to worry about getting out of the recession, establishing your recovery, making sure the recovery has really taken hold. And then, at the appropriate time, when things are all going forward, you have to switch gears and watch whether the inflation rate is coming up.” [Bullard said]
excerpted with permission

Bullard noted that the first step would not be raising the Fed Funds rate, and unwinding some of the unconventional policy. Bullard also added the Fed is concerned about asset bubbles this time:

What is different this time is that the argument about staying too low for too long is going to weigh pretty heavily on the committee. It is more than just: ‘What does the output gap look like; what does inflation look like?’ ”

He said it was also the issue of whether “you are generating the conditions that might foster a bubble that really might come back to hurt you later? I think this will be a big issue for the committee.”

My comment: historically the Fed does not raise rates until well after the unemployment rate peaks. And the Fed plans on buying MBS through the first quarter of 2010 - so Bullard's comment about starting to switch gears "a little bit into 2010" is probably way too early.

by Calculated Risk on 10/21/2009 01:30:00 PM

Yesterday both former Fed Chairman Paul Volcker and BofE Governor Mervyn King argued to break up the big banks. Fed Governor Tarullo disagrees.

From Fed Governor Daniel Tarullo: Confronting Too Big to Fail

One approach suggested by a number of commentators is to reverse the 30-year trend that allowed progressively more financial activities within commercial banks and more affiliations with non-bank financial firms. The idea is presumably to insulate insured depository institutions from trading or other capital market activities that are thought riskier than traditional lending functions. There are, however, at least two reasons why this strategy seems unlikely to limit the too-big-to-fail problem to a significant degree. One is that, historically at least, some very large institutions got themselves into a good deal of trouble through risky lending alone. Moreover, as we have already seen in the experience with Bear Stearns and Lehman, firms without commercial banking operations can now also pose a too-big-to-fail threat.

Another approach would be to attack the bigness problem head-on by limiting the size or interconnectedness of financial institutions. Some observers have even suggested that existing large firms should be split up into smaller, not-too-big-to-fail entities, in a manner a bit reminiscent of the break-up of AT&T in the early 1980s. Of course, the conceptual and practical challenges in breaking up the nation’s largest financial institutions would be considerably more daunting than those faced by Judge Greene in creating four regional operating companies and a long distance carrier out of the old AT&T. Indeed, to my knowledge, no one has offered anything like standards for undertaking this task, much less a blueprint for how it would be accomplished. This is, in other words, more a provocative idea than a proposal. Like many a provocative idea, though, even in an unelaborated form it can focus attention on the relative effectiveness of alternative policy proposals.

The fact that the largest financial firms will account for a significantly larger share of total industry assets after the crisis than they did before can only add to the uneasiness of those worried about the too-big-to-fail phenomenon. It is notable that current law provides very little in the way of structural means to limit systemic risk and the too-big-to-fail problem. The statutory prohibition on interstate acquisitions that would result in a commercial bank and its affiliates holding more than 10 percent of insured deposits nationwide is the closest thing to such an instrument. Policymakers and policy commentators alike might usefully attempt to develop similarly discrete mechanisms that could be beneficial in containing the too-big-to-fail problem. As must be apparent from my remarks today, my strong suspicion is that an effective response to the problem will likely require multiple, mutually reinforcing instruments.
emphasis added

Tarullo suggests:

A regulatory response for the too-big-to-fail problem would enhance the safety and soundness of large financial institutions and thereby reduce the likelihood of severe financial distress that could raise the prospect of systemic effects. Such a response consists of three elements.

First, the shortcomings of the regulations that failed to protect the stability of the firms and the financial system need to be rectified. Regulatory capital requirements can balance the incentive to excessive risk-taking that may arise when there is believed to be government support for a firm, or at least some of its liabilities. There is little doubt that capital levels prior to the crisis were insufficient to serve their functions as an adequate constraint on leverage and a buffer against loss. The Federal Reserve has worked with other U.S. and foreign supervisors to strengthen capital, liquidity, and risk-management requirements for banking organizations. In particular, higher capital requirements for trading activities and securitization exposures have already been agreed. Work continues on improving the quality of capital and counteracting the procyclical tendencies of important areas of financial regulation, such as capital and accounting standards.

These regulatory changes are surely a necessary part of a response to the too-big-to-fail problem, but there is good reason to doubt that they are sufficient. Generally applicable capital and other regulatory requirements do not take account of the specifically systemic consequences of the failure of a large institution. It is for this reason that many have proposed a second kind of regulatory response--a special charge, possibly a special capital requirement, based on the systemic importance of a firm. Ideally, this requirement would be calibrated so as to begin to bite gradually as a firm’s systemic importance increased, so as to avoid the need for identifying which firms are considered too-big-to-fail and, thereby, perhaps increasing moral hazard.
...
A third regulatory change is in some respects the most obvious and straightforward: Any firm whose failure could have serious systemic consequences ought to be subject to regulatory requirements such as those I have just described.