July 19, 2007
Bernanke on the economic outlook
In testimony before the U.S. Congress yesterday, Fed Chair Ben Bernanke continued his policy of greater openness and transparency for Federal Reserve policy, trying to lay out clearly what the Fed is most worried about.
Bernanke's statement included the following details:
The central tendency of the [FOMC member] growth forecasts, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2-1/4 to 2-1/2 percent this year and 2-1/2 to 2-3/4 percent in 2008. The forecasted performance for this year is about 1/4 percentage point below that projected in February, the difference being largely the result of weaker-than-expected residential construction activity this year. The unemployment rate is anticipated to edge up to between 4-1/2 and 4-3/4 percent over the balance of this year and about 4-3/4 percent in 2008, a trajectory about the same as the one expected in February.
Putting out specific numbers like this is intimidating-- we're much too chicken to do it here at Econbrowser-- since even the best numbers are sure to be wrong. Bernanke is giving us these numbers not because he's sure it's going to happen this way-- he knows it won't. But the numbers do communicate exactly what the Fed is thinking in a way that Greenspan's mushy sentences never did. The Fed's best guess is that the current slow growth rates will continue for another year, and the reason is the ongoing problems with housing:
The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening in lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment as well as by mortgage rates that--despite the recent increase--remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time.
Bernanke also acknowledged that the Fed has become more concerned about mortgage defaults:
conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower-quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk.
Bernanke's concerns, however, are not as great as those of Brad DeLong, who concludes on the basis of arguments like this one from the Irvine Housing Blog that it's time for the Fed to lower its target for the fed funds rate:
Part of the bearish argument for a dramatic drop in [house] prices is predicated on an infusion of "must sell" inventory to the housing market. Sellers won't sell at a loss unless they have no choice. This is why prices generally are sticky in a housing market decline.
Foreclosures and short sales are by their nature must-sell inventory. For this must-sell inventory to be forced onto the market people must be unable or unwilling to make the payments on their mortgage. The "unable" part will come from resetting ARMs with higher interest rates; the "unwilling" part will come from people walking away from 100% financing deals when market prices do not continue to rise.
The concern is then how broad the financial ramifications would prove to be if we see high default rates outside of the subprime categories. But I think Bernanke is unlikely to follow DeLong's advice, because the Fed Chair is in the same box he's been in all along-- fears about rising inflation. Returning to Bernanke's statement:
Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months--both unwelcome developments. As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first five months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability.
Bernanke remains hopeful, however, that the slow growth will bring inflation down. He was notably cautious about that prediction, however, offering numerical forecasts only on core rather than total PCE inflation:
The central tendency of FOMC participants' forecasts for core PCE inflation--2 to 2-1/4 percent for 2007 and 1-3/4 to 2 percent in 2008--is unchanged from February. If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters.
Bernanke noted that such an anticipation is plausible, with
futures prices suggesting that investors expect energy and other commodity prices to flatten out.
But Bernanke is also well aware that these futures-based forecasts historically have a huge forecasting error, and no one can rule out a continuation of the recent surge in energy and food prices.
All of which leaves the Fed no alternative but to keep the target fed funds rate steady for now. But I share DeLong's big worries, and suspect that Bernanke must to some degree as well. My guess is that if there is an interest rate change, a cut is more likely than an increase. The key variables to be watching at this point are real estate prices and the inventory of unsold homes.
Posted by James Hamilton at July 19, 2007 07:19 AMdigg this | reddit
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Tracked on July 19, 2007 08:44 PM
I think this section of Bernanke's comments scratches the surface of a more crucial issue than either subprime finance or housing: "For the most part, financial markets have remained supportive of economic growth . . . In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower-quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk."
The critical issue here is credit spreads, and what happens when they inevitably mean revert upwards toward normal levels.
IMH, the most significant implication of the subprime collapse was the speed and magnitude of the complete destruction of the two Bear Stearns hedge funds. Like the dead canary in the coal mine, these events expose the fragility of the capital markets to "run on the bank" systemic events.
In 1998, LTCM had about $4 billion of equity capital and around $100 billion of exposure, and its rapid-fire financial distress created systemwide stresses. Today, I don't think anyone knows exactly how much money is managed by hedge funds in the "relative value", but smart people I talk to suggest that a conservative estimate of the amount is larger than a trillion. And that's the conservative estimate - the real amount is likely considerably larger.
Because the scale is so massive, there's two risky ingredients here creating a toxic mix: (a) leverage - while the LTCM crazies were leveraged around 25-1, note that the two Bear Stearns funds (which are representative of 2007 era standards) were levered at 10-1 and 20-1, and (b) all of the relative value "geniuses" are doing pretty much the same thing - taking either credit or maturity risk (or both) on arbitraged fixed income positions to generate positive carry.
Btw, one important reason why credit spreads are near historic lows today is that there's so much leveraged capital chasing relative yield which is needed for the positive carry. And that investment success has generated more success which has generated more weight of money to push credit spreads closer. The subprime debacle and common sense suggest that the peak is now past, the game is winding down and eventually, inevitably, when the bubble unwinds it will be spectacularly fast because of the leverage and because so much money is going to try to run through the door three stooges style all at the same time.
Speaking with a long-only fixed income wizard recently, I suggested that a 150 basis point jump in credit spreads could tap out the relative value boys, and his observation was, "150 bips? With 10-20 to 1 leverage, it probably only takes 50 bp's". Sometimes I feel like I'm watching a train wreck in slow motion . . . . . . or maybe I'm just having a bad day. Sorry.
Posted by: Anarchus at July 19, 2007 08:55 AM
I'm curious to know your perception of how deeply Bernanke thinks about oil supply issues. From where I'm sitting, the issues we debate regularly of what OPEC or Saudi Arabia is going to do next, whether the current plateau in oil supply will continue or not, are the critical variables in whether oil prices will likely go down or go up, and they in turn sharply affect the Fed's room for manouever. Even the food price factor has a great deal to do with the ethanol craze, which in turn is a creature (in significant part) of recent high oil prices.
Yet in his public statements, Bernanke tends to speak of energy prices only as an exogenous variable with no specific causal factors explaining their movment. How deeply is he thinking about these things?
Posted by: Stuart Staniford at July 19, 2007 11:23 AM
Stuart, I would say that Bernanke thinks of the relative price of oil as being outside the control of U.S. monetary policy, but as something that may make a difference for the variables that monetary policy cares about (namely inflation and output). As far as predicting what will come next with oil prices, Bernanke would not think he has the ability to second-guess the futures market, on which basis he might say that no further price change is about as good a guess as anybody has, with a very big standard error for the forecast error.
Posted by: JDH at July 19, 2007 12:08 PM
What bothers me is that the FED is still locked into controlling inflation by restricting growth. The US growth rate is far below the world average and I believe that is significantly because the FED uses growth or irrational exuberance as its guide to inflation. The results is that other countries are growing faster and one day we will wonder why we are lagging behind.
JDH, Totally agree on lowering the interest rates. Actually lowering the interest rates and allowing more growth will lower inflation because of increased business activity, but the FED doesn't think this way.
Posted by: DickF at July 19, 2007 12:20 PM
Sorry I hit post before I made this point. If growth creates inflation shouldn't China have the highest inflation in the world? The why are we concerned that the Yuan is so strong?
Posted by: DickF at July 19, 2007 12:22 PM
I have a couple comments:
1) The Fed must fight inflation before unemployment or it's possible to end up with stagflation like the 70s.
2) The Case-Shiller Index peaked around 1980 and 1990 just as the past 2 out of 3 recessions began (the 3rd was caused by the tech bubble). At these 2 peaks the index rose to about 125 and then reverted back to the modern average around 110. We are currently at about 200 (uncharted territory!).
Does anyone have thoughts on the causation though? Did a slowdown in housing kick-start these 2 recessions ...or did the recessions cause housing prices to drop? I'm trying to determine if a recession is unavoidable or not. Is the Fed kidding themselves or is a soft landing actually possible after such a huge bubble?
Posted by: NoFate at July 19, 2007 07:07 PM
Scilla maybe the housing/mortgage markets, but Charybdis is the sinking dollar. The latter would argue for higher rates.
Lady or Tiger, which will it be?
Posted by: Fat Man at July 19, 2007 09:45 PM
It would be interesting to analyze this testimony and the Fed's overall performance using the assumption that there is no influence of the overnight borrowing rate inflation. As an extension of this assumption, one can also presume that inflation does not affect economic growth.
Such an approach, obviously, is not possible for a trained economist - this is the paradigm of conventional economics. Nevertheless, it can give some interesting results, which show that this heretic assumptions provide a better description of actual time series and almost fully explain the observed variability of such macro as inflation, unemployment, real GDP growth, personal income distribution.
Posted by: Ivan Kitov at July 20, 2007 02:13 AM
I know that it has always been a mistake to underestimate the Fed but I wonder if this is one of those rare occasions when "this time it's different." It seems to me that the Fed's ability to manage/manipulate economic outcomes has decreased in direct proportion to the increase in globalized markets. In fact, I happen to think that they really can only have a negative effect on the economy now. (Of course, I have become a fan of the Austrian school of economics of late and think we're freaking doomed anyway!)
Posted by: Footwedge at July 20, 2007 06:34 AM
I wish I could find the transcript of the Q&A session - I really enjoy Bernanke getting Barney Frank worked up. Unfortunately, a transcript doesn't capture the true Elmer Fudd stylings of the congressman.
Posted by: Rich Berger at July 20, 2007 07:01 AM
A genuine scarcity of crucial and largely irreplaceable industrial commodities - oil and natural gas - is going to cause economic hardship no matter the Fed policy. In that circumstance, it would seem that all the Fed can do is to choose whether the pain will show up as unemployment or inflation. It would be nice to see some acknowledgment from Bernanke that we may be facing just such a situation.
Posted by: Hal at July 24, 2007 10:20 AM