July 07, 2008
Janet Yellen on risks and prospects for the U.S. economy
This morning we were pleased to welcome Janet Yellen, President of the Federal Reserve Bank of San Francisco, to our UCSD Economics Roundtable. She focused on three main challenges: the housing slump, financial market turmoil, and commodity prices, which she likened to the three witches from Macbeth. Her complete speech is available from the FRB SFO Here are some excerpts.
Housing. Unfortunately, it appears to me that there are at least three reasons for thinking that housing prices have further to fall. First, the ratio of house prices to rents-- a kind of price-dividend ratio for housing-- still remains quite high by historical standards.... Second, inventories of unsold homes remain at elevated levels.... Third, the futures market for house prices predicts further declines in a number of metropolitan areas this year....
Financial markets. The ongoing fall in house prices has important implications for the financial markets, and it is one reason that we may continue to get troubling news from that part of the economy.... [T]he market for private-label securitized mortgages of even the highest quality remains moribund. These securities were the primary source of financing for nonconforming residential mortgages, including subprime lending. Outside of the expanded FHA lending, there is little or no lending to higher-risk residential mortgage borrowers. Jumbo mortgages for prime borrowers are available, but at historically high spreads over rates on conventional mortgages, as banks have been reluctant to make these loans....
[S]ecuritization was a key driver of the credit expansion. Financial institutions originated loans that they then bundled into securities and sold to other investors. With hindsight, it is clear that this originate-to-distribute model suffered severe incentive problems-- the originator had insufficient incentive to ensure the quality of the loans, since someone else ultimately held them. Conflicts of interest and moral hazard problems also are nested in the many other linkages in the securitization process. Before private-label mortgage securitization can recover, financial markets must design mechanisms to align the incentives of originators with the interests of the ultimate investors. Second, there was a widespread failure of risk management, both in terms of liquidity and credit risk. An important shortcoming in credit risk management was an excessive reliance on what turned out to be flawed assessments of risk by rating agencies of certain asset-backed securities. Investors, even large sophisticated financial institutions, did not take adequate steps to assess risk independently. The lack of transparency in the credit process and the complexity of many of the newer financial products did not help. Third, even with changes in contracting and financial modeling, the re-intermediation process and deleveraging more generally is likely to continue. Re-intermediation involves a larger share of financing held in the portfolios of institutions such as commercial banks and less by other investors holding securitized assets. The re-intermediation is part of deleveraging-- that is less reliance on debt and more on equity financing-- to the extent banks tend to hold more capital than other less regulated financial institutions....
The encouraging news is that large commercial banks, investment banks, and mortgage specialists have, to some extent, been able to issue new equity capital and to rebuild capital positions that have come under pressure from a combination of losses and growth in assets.
The balance-sheet pressures, and broader financial market dislocations, are likely to be with us for some time. My expectation is that market functioning will improve markedly by 2009. But things could get worse before they get better...
Commodities. On the demand side, booming economic activity in developing countries has boosted their appetite for commodities. For example, since 2000, world demand for oil has increased by roughly 11 million barrels per day, with China accounting for roughly 30 percent of this increase, and other developing countries accounting for another 60 percent....
On the supply side, there have been constraints. Oil production has become more expensive, major discoveries are increasingly difficult to find, and spare capacity to supply more oil in the short run has been declining. As a result, energy supplies have not kept pace with growing worldwide demand....
I am not yet persuaded that speculation, rather than the fundamentals of global supply and demand, has played an important role in driving up prices. For example, it should be harder to speculate and take positions on commodities that are not easy to trade on futures markets and are not included in index funds. But the prices of individual commodities that are not in index funds have risen just as fast as those that are.
In addition, if speculators were important in driving prices up, then, at the high prices now prevailing, demand by nonspeculative end users would fall short of current supply, causing inventories to rise. In fact, however, inventories appear to have been declining in most commodity markets....
Policy. Between September and April, the [Federal Open Market] Committee reduced the federal funds rate by 3-1/4 percentage points to its current rate of 2 percent. With core consumer inflation running at about the same rate, the real funds rate is now around zero. These cuts in the target rate, along with the actions to foster greater liquidity in financial markets, have mitigated the worst effects of the squeeze on spending. I am somewhat reassured by the recent data, which suggest that my biggest fears on the downside have, so far, been avoided. Of course, the underlying housing, credit, and commodity-price issues are far from fully resolved. My discussion of those issues makes clear that a lot of uncertainty surrounds my outlook. A lot could still go wrong.
But maximum sustainable employment is only one of our mandates. The other is low and stable inflation. In the wake of rapid increases in prices for gasoline and food, consumer survey measures of longer term inflation expectations have turned up. In contrast, other surveys, such as the Survey of Professional Forecasters, show little erosion in long-term inflation expectations. In addition, the anecdotes I hear are more consistent with credibility than with an upward wage-price spiral. In particular, my contacts uniformly report that they see no signs of general wage pressures.
On balance, I still see inflation expectations as reasonably well anchored and I anticipate that consumer survey measures will come down once oil and food prices stop rising. But the risks to inflation are likely not symmetric and they have definitely increased. We cannot and will not allow a wage-price spiral to develop.
Yellen portrays a Federal Reserve that remains deeply troubled about risks to both real economic activity and to inflation. It seems she personally may be a little more frightened by the former, with her words containing no hint that the commodity price trends she mentions might have something to do with that 3-1/4 percent rate cut that she and her colleagues have voted for.
I presume that Yellen and her colleagues must see the possibility that Fed policy has contributed to the commodity price run-up as clearly as the rest of us. But I conclude that the first two witches-- particularly the second-- must still be scaring her the most.
Posted by James Hamilton at July 7, 2008 10:19 AMdigg this | reddit
I can see Dubya as Macbeth, but who plays Banquo's ghost?
Posted by: Charles at July 7, 2008 10:36 AM
You know, point of fact, all the Fed easing hasn't made mortgage rates go down one bit.
Maybe the Fed can't do anything about 1 and 2? And they're ignoring their role in #3, no doubt.
We live in interesting times...
Posted by: Buzzcut at July 7, 2008 01:54 PM
Pretty much the standard stuff.
What I don't see are any solutions. That is very understandable because the privately owned and operated Federal Reserve is the manifestation of the problem, that is fractional reserve banking which in fact is leveraged debt banking.
The whole concept of debt leveraged banking is unlimited growth based on exponential debt expansion.
We now face the limits of growth on several fronts. The Environment and it's ability to absorb our pollution, commodities and the negative real rate of extraction and in turn debt, that can't be underwritten with a negative rate of return.
Since our money is created by debt being monetized at leveraged proportions the shrinking of debt will destroy money which is the providence of the banks and by extension the Federal Reserve itself.
When is the last time you heard a bureaucrat call for the elimination of their own bureaucracy? In any case the banks will hold on to their money making monopoly until hundreds of millions if not billions of people are dead, and even then have to be forced to relinquish their debt pyramid scheme.
Posted by: Michael McKinlay at July 7, 2008 03:32 PM
> We cannot and will not allow a wage-price spiral to develop.
....in the US.
We cannot, however, do a damn thing about a price spiral, sans US-wage increases....but I really don't want to talk about that, so I won't.
Posted by: KnotRP at July 7, 2008 05:07 PM
I may be out of topic but i got a question if someone here knows about it. Which are the volume of oil in contract and spot based transactions? I read in a 90s article that 80% of the traded volume were traded using benchmarks like WTI and Brent. But in Yves Smith blog is an analysis about how some contracts are maded using futures prices instead benchmark to define the formula pricing.
So, the question is, how many of the contracts are maded using benchmark and how many are based in the price of futures? And also, how many barrels are traded at spot price?
If someone has info about it, please help. Thanks
Posted by: Carlos at July 7, 2008 06:29 PM
I don't agree with commodities point of view, we need to take in account (to estimate oil price) the underground inventories and the different kind of crude oil and conversion refining capacity...
Posted by: Willy at July 7, 2008 09:32 PM
Why should a private bank be able to print money, be able to lend this money to the federal government, and charge the federal government interest? The federal reserve is a private bank which pays its stock holders (national private banks) 6 percent dividends on their shares. If the government needs to print money, the government should print it interest free. Then, at least the taxpayers would not have to pay additional taxes to pay the interest for the banks dividends. I am against all paper money, but if we are going to have a fiat currency and print money, we should at least print it interest free.
Posted by: GoldLeader at July 8, 2008 04:25 AM
Janet Yellen is, I believe, right to say that the rise in commodity prices is more due to fundamentals rather than commodity trading speculation. Inventories of many commodities are at 50-60 year lows.
If we just consider crude oil where there has been much concern about speculators driving the prices higher.
Consider this. Unleaded gasoline is a distillate of light, sweet crude oil and a fall in supply of this grade of crude will cause prics of both RBOB and crude oil futures to rise on the New York Mercantile Exchange (NYMEX).
The problem is that there is more heavy, sour crude oil available than the lighter grade West Texas Intermediate (WTI) which is the US benchmark on NYMEX.
So when Saudi Arabia announced at the recent Jeddah Oil Summit that they would increase output by a further 300,000 barrels a day, NYMEX WTI actually rose in New York.
This is because increasing supply of heavy sour will not bring down the price of light, sweet by the amount everyone desires. It is like offering someone pepper at the restaurant table when they asked for salt.
The solution. Urgent investment in new refining capacity able to process the sour crude oil into unleaded gasoline.
Posted by: David Phillips at July 8, 2008 07:27 AM
Thanks Professor. The comments from Yellen are very telling.
On housing: There does not seem to be any question on her part about the over-extension of credit by lending institutions at the expense of productive lending. The siren call of real estate that is booming is stronger than reason for too many institutions and that his especially true when government taxes and regulation favors real estate loans over other loans. The inflated money supply was almost force fed to the real estate market.
On financial markets: She is correct to identify real estate as a serious problem for the same reasons as I explain above. Loanable funds went to real estate primarily because of government policy.
On commodity prices: Thanks you Professor for pointing out the obvious.
Posted by: DickF at July 8, 2008 09:48 AM
It is instructive to read Yellen's comments in context with the comments of other members of the FED.
William Poole who only recently left the FED in the German daily Frankfurter Allgemeine Zeitung
gave interesting insight into FED thinking. “In historical perspective inflation is a means to diminish the stress felt by debtors. The policy of the US central bank is construed to create inflation to alleviate that stress. Its monetary policy was, is, and will be "lax" until the economic situation, and the situation of financial firms, will be improved. All in all this will entail an inflationary tendency, even if the latter will entail a bundle of new problems in another three or four more years.”
In other words the FED will intentionally create inflation to benefit debitors at the expense of creditors regardless of the impact on the economy.
Then in Frankfort on June 26, 2008, Fed Vice Chairman, Donald Kohn said central banks should essentially weaken their economies in order to fight inflation. He stated: "...in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability."
If he believes this for foreign countries wouldn’t he assume the same theory for the US economy, in order to fight inflation the US should weaken its economy? Coupled with the statement by Poole the FED will intentionally harm the economy to correct for the inflation that they intentionally create.
Now looking at Yellen's comment on policy we can see her words in a much more ominous light. She wrote: "On balance, I still see inflation expectations as reasonably well anchored and I anticipate that consumer survey measures will come down once oil and food prices stop rising. But the risks to inflation are likely not symmetric and they have definitely increased. We cannot and will not allow a wage-price spiral to develop."
From these comments is there really any doubt that the FED through their central planning of monetary policy is creating an absolute mess of our economy and that much is intentional.
Posted by: DickF at July 8, 2008 12:03 PM
The following was written by a chef for comments on his economic reasoning, he does not claim to be an economist. What I wonder is if a chef can understand this why can't economists? Even more important how can the FED governors and congress be so blind to common sense?
Many of the problems we are seeing are caused by a drop in the demand for dollars. This begs the question, why is there a drop in dollar demand? In the '80's, the Reagan Administration was for easing the regulatory burden, cutting taxes and providing a sound currency. This proved a bonanza for our economy as capital flowed into the US. Bit by bit over the last 25 years, our overseas competitors have made their economies friendlier to investors, while bit by bit we have made ours gradually worse. Investors seeks the best combination of return on investment and low risk and, for a number of reasons, the real after-tax return for investments made in the US are no longer better than those in other economies. Low-risk investors can find safe investments in Europe and high-risk investors can find many options in Asia. As investors find better returns elsewhere, the demand for dollars drops. With no offsetting drop in the supply of dollars, the price of the gold in dollars has skyrocketed. This has been a major factor in the inflation of the last year. The markets are doing what markets do, trying to predict the future. The markets are betting that not only will the demand for dollars drop further, as anti-business, pro-tax, pro-regulation, pro-lawyer Democrats take complete control of the federal government, but they are guessing that the money supply will not be adjusted to offset this drop in demand. This predicted drop in dollar demand is pretty much a sure bet, since a component of the favorable business climate in the US was the Bush tax cuts which are set to expire and unlikely to be renewed. The Federal Reserve is in no mood to tighten significantly, because it has been dealing with the problem of subprime mortgages. It doesn't help that both presidential canditates are also proposing to add huge new costs to American industry in the areas of health care and reducing carbon emissions which will have to be paid for somehow. Obama in particular wants to punish the greedy, ie. anyone making a profit. The combination of these anti-business factors is causing investors to shun the US. All of this is made worse by lawmakers who clearly have no clue what to do and have platforms that would make things worse. We can expect continued inflation as weaker dollars are unable to buy as many goods from overseas. Decrease in American demand is likely to harm the economies of our trading partners, particularly China.
What should be done? When you are doing everything wrong, the solution is simple. Stop it. Since we are competing with other nations to get the worlds investors to supply our industry with capital, we need to provide an environment that convinces them that investing here will benefit them. If you invest long-term, you have to believe that you can both make a profit and will get to keep that profit. If regulations are so burdensome that they impact profits too strongly, the investment will be made where regulations are not so strict (or where regulators can be bribed). If the courts treat torts like a lottery and confiscate hard-earned profits to punish companies that are operating in good faith, this increases the risk of making investments in that country. If tax policy is confiscatory, capital will be invested where government takes a smaller cut. If a country debases its currency, other nations will not want to trade in that currency.
So what should we do? We need to create an environment that encourages capital investment. The cost of doing business could be be lowered by reducing regulatory burdens on business. Tort reform could likewise lower risks and costs. Finally, reductions in corporate tax rates would increase return on investment. Finally, pegging the dollar to a gold-price target would convince investors that the return on their investments would not be made in dollars which are worth much less than the ones that made the investment. Until policy makers get this, it would probably be wise to short the dollar and buy gold and commoditites, art, and collectibles.
Posted by: DickF at July 9, 2008 05:42 AM
It looks like the FED is not the only folks who don't know what they are saying or what is going on. Today Treasury Secretary Paulson was questioned by Ron Paul about the value of the dollar (shown on CNBC). The market had been up 100 pts then promptly dropped into the negative and gold shot up $15. They are doing more damage by accident than they ever could intentionally.
Posted by: DickF at July 10, 2008 02:08 PM