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Bad News Bears

The evidence continues to mount that the U.S. may already be in a recession. A Federal Reserve report released this week indicates the economy is losing steam quickly driven by higher fuel prices, a persistent housing slump, and tighter credit standards. The Nielsen Company found that 49% of U.S. consumers are reducing their spending to compensate for rising gas prices by combining shopping trips and errands, eating out less and staying home more often. Meanwhile, MD-based ChangeWave found that 60% of consumers surveyed said they had less money to spend during the holidays due to increased gas prices. Last week the “RBC CASH Index” for January plummeted to its lowest level since data collection began in 2002. This week top credit card issuers reported a sharp up tick in losses and rising delinquency, according to CardWeb.com.

Chairman Ben S. Bernanke
The economic outlook
Before the Committee on the Budget, U.S. House of Representatives
January 17, 2008

Chairman Spratt, Representative Ryan, and other members of the
Committee, I am pleased to be here to offer my views on the near-term
economic outlook and related issues.

Developments in Financial Markets
Since late last summer, financial markets in the United States and in a
number of other industrialized countries have been under considerable
strain. Heightened investor concerns about the credit quality of
mortgages, especially subprime mortgages with adjustable interest rates,
triggered the financial turmoil. Notably, as the rising rate of
delinquencies of subprime mortgages threatened to impose losses on
holders of even highly rated securities, investors were led to question
the reliability of the credit ratings for a range of financial products,
including structured credit products and various special-purpose
vehicles. As investors lost confidence in their ability to value
complex financial products, they became increasingly unwilling to hold
such instruments. As a result, flows of credit through these vehicles
have contracted significantly.

As these problems multiplied, money center banks and other large
financial institutions, which in many cases had served as sponsors of
these financial products, came under increasing pressure to take the
assets of the off-balance-sheet vehicles onto their own balance sheets.
Bank balance sheets were swelled further by holdings of nonconforming
mortgages, leveraged loans, and other credits that the banks had
extended but for which well-functioning secondary markets no longer
existed. Even as their balance sheets expanded, banks began to report
large losses, reflecting marked declines in the market prices of
mortgages and other assets. Thus, banks too became subject to valuation
uncertainty, as could be seen in the sharp movements in their share
prices and in other market indicators such as quotes on credit default
swaps. The combination of larger balance sheets and unexpected losses
prompted banks to become protective of their liquidity and balance sheet
capacity and thus to become less willing to provide funding to other
market participants, including other banks. Banks have also evidently
become more restrictive in their lending to firms and households.
More-expensive and less-available credit seems likely to impose a
measure of restraint on economic growth.

The Outlook for the Real Economy
To date, the largest effects of the financial turmoil appear to have
been on the housing market, which, as you know, has deteriorated
significantly over the past two years or so. The virtual shutdown of
the subprime mortgage market and a widening of spreads on jumbo mortgage
loans have further reduced the demand for housing, while foreclosures
are adding to the already-elevated inventory of unsold homes. New home
sales and housing starts have both fallen by about half from their
respective peaks. The number of homes in inventory has begun to edge
down, but at the current sales pace the months’ supply of new homes has
continued to climb, and home prices are falling in many parts of the
country. The slowing in residential construction, which subtracted
about 1 percentage point from the growth rate of real gross domestic
product in the third quarter of 2007, likely curtailed growth even more
in the fourth quarter, and it may continue to be a drag on growth for a
good part of this year as well.

Recently, incoming information has suggested that the baseline outlook
for real activity in 2008 has worsened and that the downside risks to
growth have become more pronounced. In particular, a number of factors,
including continuing increases in energy prices, lower equity prices,
and softening home values, seem likely to weigh on consumer spending as
we move into 2008. Consumer spending also depends importantly on the
state of the labor market, as wages and salaries are the primary source
of income for most households. Labor market conditions in December were
disappointing; the unemployment rate increased 0.3 percentage point, to
5.0 percent from 4.7 percent in November, and private payroll employment
declined. Employment in residential construction posted another
substantial reduction, and employment in manufacturing and retail trade
also decreased significantly. Employment in services continued to grow,
but at a slower pace in December than in earlier months. It would be a
mistake to read too much into one month’s data. However, developments
in the labor market will bear close attention.

In the business sector, investment in equipment and software appears to
have been sluggish in the fourth quarter, while nonresidential
construction grew briskly. In light of the softening in economic
activity and the adverse developments in credit markets, growth in both
types of investment spending seems likely to slow in coming months.
Outside the United States, however, economic activity in our major
trading partners has continued to expand vigorously. U.S. exports will
likely continue to grow at a healthy pace in coming quarters, providing
some impetus to the domestic economy.

Financial conditions continue to pose a downside risk to the outlook.
Market participants still express considerable uncertainty about the
appropriate valuation of complex financial assets and about the extent
of additional losses that may be disclosed in the future. On the whole,
despite improvements in some areas, the financial situation remains
fragile, and many funding markets remain impaired. Adverse economic or
financial news thus has the potential to increase financial strains and
to lead to further constraints on the supply of credit to households and
businesses.

Even as the outlook for real activity has weakened, some important
developments have occurred on the inflation front. Most notably, the
same increase in oil prices that may be a negative influence on growth
is also lifting overall consumer prices. Last year, food prices also
increased exceptionally rapidly by recent standards, further boosting
overall consumer price inflation. The most recent reading on overall
personal consumption expenditure inflation showed that prices in
November were 3.6 percent higher than they were a year earlier. Core
price inflation (which excludes prices of food and energy) has stepped
up recently as well, with November prices up almost 2-1/4 percent from a
year earlier. Part of this rise may reflect pass-through of energy
costs to the prices of core consumer goods and services, as well as the
effects of the depreciation of the dollar on import prices, although
some other prices–such as those for some medical and financial
services–have also accelerated lately.1

Thus far, the public’s expectations of future inflation appear to have
remained reasonably well anchored, and pressures on resource utilization
have diminished a bit. Further, futures markets suggest that food and
energy prices will decelerate over the coming year. Given these
factors, overall and core inflation should moderate this year and next,
so long as the public’s confidence in the Federal Reserve’s commitment
to price stability is unshaken. However, any tendency of inflation
expectations to become unmoored or for the Fed’s inflation-fighting
credibility to be eroded could greatly complicate the task of sustaining
price stability and reduce the central bank’s policy flexibility to
counter shortfalls in growth in the future. Accordingly, in the months
ahead we will be closely monitoring the inflation situation,
particularly inflation expectations.

Monetary Policy Response
The Federal Reserve has taken a number of steps to help markets return
to more orderly functioning and to foster its economic objectives of
maximum sustainable employment and price stability. Broadly, the
Federal Reserve’s response has followed two tracks: efforts to improve
market liquidity and functioning and the pursuit of our macroeconomic
objectives through monetary policy.

To help address the significant strains in short-term money markets, the
Federal Reserve has taken a range of steps. Notably, on August 17, the
Federal Reserve Board cut the discount rate–the rate at which it lends
directly to banks–by 50 basis points, or 1/2 percentage point, and it
has since maintained the spread between the federal funds rate and the
discount rate at 50 basis points, rather than the customary 100 basis
points. In addition, the Federal Reserve recently unveiled a term
auction facility, or TAF, through which prespecified amounts of discount
window credit can be auctioned to eligible borrowers. The goal of the
TAF is to reduce the incentive for banks to hoard cash and increase
their willingness to provide credit to households and firms. In
December, the Fed successfully auctioned $40 billion through this
facility. And, as part of a coordinated operation, the European Central
Bank and the Swiss National Bank lent an additional $24 billion to banks
in their respective jurisdictions. This month, the Federal Reserve is
auctioning $60 billion in twenty-eight-day credit through the TAF, to be
spread across two auctions. TAF auctions will continue as long as
necessary to address elevated pressures in short-term funding markets,
and we will continue to work closely and cooperatively with other
central banks to address market strains that could hamper the
achievement of our broader economic objectives.

Although the TAF and other liquidity-related actions appear to have had
some positive effects, such measures alone cannot fully address
fundamental concerns about credit quality and valuation, nor do these
actions relax the balance sheet constraints on financial institutions.
Hence, they alone cannot eliminate the financial restraints affecting
the broader economy. Monetary policy (that is, the management of the
short-term interest rate) is the Fed’s best tool for pursuing our
macroeconomic objectives, namely to promote maximum sustainable
employment and price stability.

Monetary policy has responded proactively to evolving conditions. As
you know, the Federal Open Market Committee (FOMC) cut its target for
the federal funds rate by 50 basis points at its September meeting and
by 25 basis points each at the October and December meetings. In total,
therefore, we have brought the federal funds rate down by 1 percentage
point from its level just before the financial strains emerged. The
Federal Reserve took these actions to help offset the restraint imposed
by the tightening of credit conditions and the weakening of the housing
market. However, in light of recent changes in the outlook for and the
risks to growth, additional policy easing may well be necessary. The
FOMC will, of course, be carefully evaluating incoming information
bearing on the economic outlook. Based on that evaluation, and
consistent with our dual mandate, we stand ready to take substantive
additional action as needed to support growth and to provide adequate
insurance against downside risks.

Financial and economic conditions can change quickly. Consequently, the
FOMC must remain exceptionally alert and flexible, prepared to act in a
decisive and timely manner and, in particular, to counter any adverse
dynamics that might threaten economic or financial stability.

A number of analysts have raised the possibility that fiscal policy
actions might usefully complement monetary policy in supporting economic
growth over the next year or so. I agree that fiscal action could be
helpful in principle, as fiscal and monetary stimulus together may
provide broader support for the economy than monetary policy actions
alone. But the design and implementation of the fiscal program are
critically important. A fiscal initiative at this juncture could prove
quite counterproductive, if (for example) it provided economic stimulus
at the wrong time or compromised fiscal discipline in the longer term.

To be useful, a fiscal stimulus package should be implemented quickly
and structured so that its effects on aggregate spending are felt as
much as possible within the next twelve months or so. Stimulus that
comes too late will not help support economic activity in the near term,
and it could be actively destabilizing if it comes at a time when growth
is already improving. Thus, fiscal measures that involve long lead
times or result in additional economic activity only over a protracted
period, whatever their intrinsic merits might be, will not provide
stimulus when it is most needed. Any fiscal package should also be
efficient, in the sense of maximizing the amount of near-term stimulus
per dollar of increased federal expenditure or lost revenue. Finally,
any program should be explicitly temporary, both to avoid unwanted
stimulus beyond the near-term horizon and, importantly, to preclude an
increase in the federal government’s structural budget deficit. As I
have discussed on other occasions, the nation faces daunting long-run
budget challenges associated with an aging population, rising
health-care costs, and other factors. A fiscal program that increased
the structural budget deficit would only make confronting those
challenges more difficult.

Thank you. I would be pleased to take your questions.

Footnotes

1. Prices for some financial services are implicit; for example,
depositors may pay for “free” checking services only indirectly, by
accepting a lower interest rate on their deposits. The Bureau of Labor
Statistics uses estimates of such prices, as well as other nonmarket
prices, in calculating the inflation rate. Return to text

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