The Current Economic Situation
or How Did We Get Here?
Fed Challenge 2008
Orientation Program
Federal Reserve Bank of New York
Raymond Stone
Stone & McCarthy Research Associates
December 14, 2007
From October 31 FOMC Meeting
Too Easy for Too Long?
(2003/2005)
Taylor’s Estimated Trajectory of
Housing Starts
Low Funds Rate Induced Low
ARM Rates
Not Surprisingly Applications for
ARMs Surged
Now After the Funds Rate Has Been
“Normalized” These ARMs are Resetting At
Higher Rates
Meanwhile Builders Constructed More New
Homes Than Were Being Sold
The Inventory of New Unsold Homes
Reached a New Record
The Bloated Inventories of Both New and Existing
Homes on the Market Put Downward Pressure on
Home Prices
FOMC Has Maintained Focus on Mandated
Dual Objectives
• Maximum Sustainable Growth &
Employment
• Price Stability
Arguably Growth Has Been Close to
Potential, or Maximum Sustainable
And Most Gauges of Resource Utilization
Remained Tight
The Core PCE Deflator Tucked Into an
Acceptable Zone—But Can It Stay in This
Zone?
Inflation Issues for the FOMC
• The Persistence of High Energy Prices
Risks Higher Core Inflation
• Weak Dollar Has Been Associated With
Sharp Gains in Import Prices
• Food Prices Have Been Rising Quickly
• The Key to Sustainable Price Stability is
Well-Anchored “Inflationary Expectations”
Is the Fed Responsible for Fueling
Speculative Excesses in Housing?
• John Taylor (Taylor Rule) feels that the Fed kept rates too
low for too long. Had the Fed followed the Taylor Rule
during the 2003/2005 the housing boom and burst would
have been more contained.
• Both Greenspan and Bernanke regard the improbable but
corrosive effects of the deflationary risks in 2003 as
justification for taking the funds rate down to 1%, and for
keeping rates low for a “considerable period”.
• Greenspan and Bernanke note that long term rates failed to
rise as the Fed began raising the funds target, and that this
fostered stronger housing activity than otherwise.
So Who Is To Blame?
• Taylor blames the Fed for keeping rates too low
for too long
• Regulators should have been more proactive
• Securitization of mortgages, shifting risk from
direct lenders to a broad spectrum of investors
• Rating Agencies
• Risky mortgage instruments, and little discipline
on the part of mortgage brokers
• Naïve Public—”If a bank is willing to make me a
loan, they must think I will be able to repay”
No Matter Who Is To Blame—The Resulting
Credit Market Strains Represent Downside
Risks to the Economy
• Subprime related losses have diminished bank
capital, and have rendered banks more restrictive
in lending policies
• Money market conditions have become strained
increasing costs to borrowers
• Credit market difficulties have turned borrowers
away from the CP market, to banks, resulting in
some unusual and potentially problematic issues
for the inter-bank funding markets
Money Market Funds Stopped
Buying ABCP
Issuers of ABCP (Including the so-called
SIVs) Turned to Banks for Funding
Banks Faced with Increased Credit Demand,
Are Aggressively Attempting to Fund this
Demand
Inter-Bank Term Funding Costs
Have Increased
What Has the Fed Done In Response to These
Developments?
• Provided Liquidity as needed via Open Market Operations
• Extended term of discount window advances up to 30days, and reduced the spread between the Discount Rate
and Funds Rate Target to 50bps from 100 bps previously
• Lowered the Funds Rate Target to contain the “real side”
dislocations stemming from credit market turmoil.
• Announced intentions to auction discount window credit to
banks