Economic Commentary

After completing its two-day meeting, the FOMC, the Fed’s policy arm, announced today that, for a sixth consecutive time, it kept its target for the federal funds rate unchanged at 5 ¼ percent.  This was universally expected.  Also, as expected from a central bank, the Fed repeated its concern about inflation.   “Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures,” the Fed declared.  This paragraph replaces this statement of the January 31 press release.  “Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.”  Translation:  The economy is experiencing more inflation than in January.

What about economic growth, the second of the Fed’s two mandates?  The prospects for growth also worsened:  “Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.”  (Emphasis added.) The January 31 release states: “Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.”  Even though both statements  end with the assessment of growth at a moderate pace, today’s press release is less optimistic about the housing sector.  In January, “signs of stabilization have appeared in the housing market.”  Not so today: “Recent indicators have been mixed and the adjustment in the housing sector is ongoing.”  The Fed is concerned with the outlook of the housing market.

Perhaps, the ongoing problems with the “sub-prime” housing loans may have tipped the scales in favor of a softening of the Fed’s bias toward raising the federal funds rate in the future.  In January, the Fed spoke of “additional firming, i.e., raising the interest rate, whereas the Fed now speaks of “future policy adjustments,” which, of course, could be a lowering of the federal funds rate.  This seems the big news of today’s press release.

The State of U.S. Banking

Three news items in the “Money & Investing section of today’s Wall Street Journal do not make a good reading for the banking sector, and, by extension, for the economy.  The first, No Worries:  Banks Keeping Less Money in Reserve—Every Dollar Set Aside Can Cut Into Profits, by Robin Sidel and David Reilly, starts this way:

Banks might be putting too much faith in their borrowers.

As more consumers and companies start having difficulty paying their debts, the funds that banks set aside to cover soured loans stand at the lowest level since at least 1990.

•  The Issue: Banks have sharply lowered the level of their reserves, set aside to take care of loans that go bad.

•  Background: Consumers and companies alike are having trouble paying debts, so it may not be a good time to have low reserves.

•  What’s Next: Will regulators step in? Higher reserves also mean lower bank profits.

The situation is causing consternation among regulators. And as credit quality begins to deteriorate from unusually strong levels, the issue also is causing jitters on Wall Street, where analysts predict the need to boost loan-loss reserves will cut into banking-industry profits this year.

Banks establish reserves for a portion of loan portfolios or big individual loans that they estimate could go unpaid. The reserves ensure that banks have enough capital to cover any losses from loans that go bad.

But each increase in those reserves results in a charge that cuts into banks’ profits.

The second article, Subprime Game’s Reckoning Day, by Karen Richardson and Gregory Zuckerman, starts this way:

The worst may be yet to come for mortgage lenders. And that could add to investor nervousness.

Shares of companies that specialize in lending to riskier borrowers or offer unconventional loans have tumbled because of concerns over how rapidly these mortgages are going sour.

If these so-called subprime borrowers continue to have problems paying their debts, the lenders that target them likely will have to boost how much money they set aside for bad loans, cutting into their bottom lines. That could mean even lower stock prices.

There also is a concern that if the real-estate market remains cool, some borrowers with better credit histories might also begin struggling to make payments on certain popular, but unorthodox, mortgages. These types of loans allow borrowers to skip monthly payments, carry low short-term teaser rates or don’t require detailed financial documentation. If that happens, companies such as BankUnited Financial Corp. and Countrywide Financial Corp. could suffer.

When a company keeps its reserve low, it makes its earnings look better because it continues to increase its assets from loans it originates and sells off. That holds down expenses.

But when a company beefs up those reserves and the change hits its earnings, that can impair its ability to borrow the short-term funds needed to write new mortgages. Lenders need to set aside reserves to cover any possible losses when borrowers fail to make payments.

Subprime-mortgage lenders generally sell most of their loans to investors, but many keep some loans as investments. These portfolios have grown as the number of new mortgages has risen.

And the third, article, by E. S. Browning, Greenspan, Even Out of Fed, Still Steals the Stock Show, start this way:

Alan Greenspan isn’t Federal Reserve chairman any more, but he still can move markets.

After Mr. Greenspan told a Hong Kong business conference, via satellite, that a recession is “possible” later this year, U.S. stocks slumped and bond yields declined, pushing bond prices higher.

Grim reading, indeed.

The Bank of Japan, BOJ, raised interest rates by 25 basis points to 50 basis points, or 0.5 percent, yesterday.  With consumer inflation at 0.1 percent and core inflation negative, is this a good move?  Not, according to today’s editorial in the Financial Times:

The best that can be said for yesterday’s quarter-point rise in Japanese interest rates is that it is too small to do damage to the economic recovery. But the case for an increase remains as weak as when the Bank of Japan last met, in January. Consumer prices, including energy, are rising at only 0.1 per cent annually and, as the BoJ has admitted, may stay flat for some time. Wage inflation is muted, while signs of asset inflation are few and far between.

All this has fed suspicions that, despite denials by both sides, the BoJ deferred action last month under strong pressure from the government. The bank may have got its way this time, but at the price of sowing doubts about its authority, which a rate rise was supposed to restore. Whether the unprecedented opposition to yesterday’s move by one of the bank’s deputy governors is a sign of healthy dissent or divisions is a matter for debate.

Regrettably, the news that Toshihiko Fukui, the governor, had proposed a rise leaked out while the meeting was in progress. This is the latest in a steady flow of leaks over the months about the BoJ’s supposedly confidential deliberations. Such weak discipline, along with poor signalling in the bank’s official pronouncements, weakens the perceived integrity of policy-making and unsettles the markets.

The latter are unlikely to gain much clarity about the future direction of policy from yesterday’s statement explaining the decision. Subdued inflation may rule out a further interest rate rise for the next few months. Beyond then, the criteria that will guide future decisions remain opaque.

Officially, the BoJ’s policymaking framework is forward-looking. However, it has muddied the waters by using some past developments, notably a rebound in fourth quarter growth, to justify the rate increase.

The impression remains that the BoJ’s fixed point is its determination to raise interest rates as rapidly as possible to what it considers “normal” levels. However, with inflation still negative after energy prices are excluded - as is normal in other advanced economies - its reasons for seeking almost any opportunity to tighten policy are unpersuasive.

The BoJ needs to restore discipline to its policymaking and confidence to the markets. The best way to do so is to adopt a clearly specified inflation target. Its existing goal of keeping inflation broadly at between 0 per cent and 2 per cent is both too low and too loose, being based on a composite of individual board members’ objectives.

Unfortunately, Mr Fukui has ruled out such a move, as has the government, which is reluctant to be seen to impose its will on the BoJ. For the sake of the bank’s credibility, as well as of sound economic management, Mr Fukui should reconsider. The health of the world’s second biggest economy is too important to be left to the vagaries of today’s highly discretionary.

(Formerly) Humphrey-Hawkins

Fed chairman Ben Bernanke presented the Semiannual Monetary Policy Report to Congress ( formerly, the Humphrey-Hawkins Report) to the “Committee on Banking, Housing, and Urban Affairs of the U.S. Senate” today.  Here we can see some selected passages from the Accompanying Testimony of Mr. Bernanke:

Real activity in the United States expanded at a solid pace in 2006, although the pattern of growth was uneven. After a first-quarter rebound from weakness associated with the effects of the hurricanes that ravaged the Gulf Coast the previous summer, output growth moderated somewhat on average over the remainder of 2006. Real gross domestic product (GDP) is currently estimated to have increased at an annual rate of about 2-3/4 percent in the second half of the year.

…………………………………..

Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen, in large part as a result of declines in the price of crude oil. Readings on core inflation–that is, inflation excluding the prices of food and energy–have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated.

As to the outlook these passages are of interest.  First the outlook on GDP and Unemployment:

Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the members of the Board of Governors and presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts–which are based on the information available at that time and on the assumption of appropriate monetary policy–is for real GDP to increase about 2-1/2 to 3 percent in 2007 and about 2-3/4 to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. This difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4-1/2 to 4-3/4 percent.

……………………………………..

Next, on inflation:

The projections of the members of the Board of Governors and the presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next. In particular, the central tendency of those forecasts is for core inflation–as measured by the price index for personal consumption expenditures excluding food and energy–to be 2 to 2-1/4 percent this year and to edge lower, to 1-3/4 to 2 percent, next year. But as I noted earlier, the FOMC has continued to view the risk that inflation will not moderate as expected as the predominant policy concern.

The State of U.S. Banking

The traditional business of banking is to attract deposits and make loans to commerce and industry, commercial real estate, and household mortgages. The Fed’s monthly Senior Loan Officer Opinion Survey on Bank Lending Practices is a good indicator of the health of banks. The just released January 2007 survey provides a mixed, at best, reading. The most interesting part of the survey is the part on “special questions on the outlook of loan quality in 2007,” obviously of concern to the Fed and other bank regulators. Here it is:

A final set of special questions queried banks about their outlook for delinquencies and chargeoffs on their loans to businesses and households in 2007 under the assumption that economic activity will progress in line with consensus forecasts. Overall, the responses suggest that banks expect a deterioration in loan quality this year. About 45 percent of domestic respondents, on net, reported that they expect the quality of their loans to businesses—including both C&I and commercial real estate loans—to deteriorate somewhat. At U.S. branches and agencies of foreign banks, the fraction of respondents that expected a decline in the credit quality of loans to businesses was somewhat smaller. About 35 percent of domestic institutions, on balance, indicated that they anticipate that the quality of both credit card and non-credit-card consumer loans will deteriorate in 2007. A similar net fraction of domestic respondents reported that they expect the quality of their traditional residential mortgages to decline. One-half of domestic banks, on net, reported that they expect a worsening of the quality of their nontraditional residential mortgage loans this year; a few institutions noted that they anticipate that the quality of such loans will deteriorate substantially in 2007. (Italics added.) Banks were asked the same set of special questions about their outlook for loan quality in the January 2006 survey. A year ago, the net fraction of institutions that anticipated some deterioration in credit quality was notably smaller for loans to both businesses and households.

What are the reasons for the deterioration? “Demand for commercial real estate loans at [domestic banks] was said to have weakened over the past three months. ….In the household sector, domestic respondents noted that they tightened credit standard on residential mortgage loans over the survey period, while demand for such loans continued to weaken,” the Fed’s survey states in the first paragraph.

What is the danger from the low quality of bank loans? It stems from two relatively recent financial innovations, securitization, and sub-prime lending. The first refers to the repackaging of bank loans and selling them to investment banks and individual investors. As the quality of the underlying loans falls, the quality of these securities also falls, which, sooner or later, will cause a substantial fall in the price of such securities. Feeding this loan-quality deterioration is the new practice of loans to bad risks, “lemons,” at exotic terms such as interest-only payments. These fears seem have already begun to materialize, as noted in Friday’s Wall Street Journal. The Journal also notes that another innovation, “the collateralized debt obligation, or CDO, has made it possible for far more investors to make bets on U.S. mortgages. They are akin to mutual funds. By investing in a single CDO, investors can gain exposure to hundreds of different mortgage securities of varying quality.”

If such fears become widespread, the danger to banking, to financial markets, and the entire economy will be substantial.

The State of U.S. Banking

The traditional business of banking is to attract deposits and make loans to commerce and industry, commercial real estate, and household mortgages.  The Fed’s monthly Senior Loan Officer Opinion Survey on Bank Lending Practices is a good indicator of the health of banks.  The just released January 2007 survey provides a mixed, at best, reading.  The most interesting part of the survey is the part on “special questions on the outlook of loan quality in 2007,” obviously of concern to the Fed and other bank regulators.  Here it is:

A final set of special questions queried banks about their outlook for delinquencies and chargeoffs on their loans to businesses and households in 2007 under the assumption that economic activity will progress in line with consensus forecasts. Overall, the responses suggest that banks expect a deterioration in loan quality this year. About 45 percent of domestic respondents, on net, reported that they expect the quality of their loans to businesses—including both C&I and commercial real estate loans—to deteriorate somewhat. At U.S. branches and agencies of foreign banks, the fraction of respondents that expected a decline in the credit quality of loans to businesses was somewhat smaller. About 35 percent of domestic institutions, on balance, indicated that they anticipate that the quality of both credit card and non-credit-card consumer loans will deteriorate in 2007. A similar net fraction of domestic respondents reported that they expect the quality of their traditional residential mortgages to decline. One-half of domestic banks, on net, reported that they expect a worsening of the quality of their nontraditional residential mortgage loans this year; a few institutions noted that they anticipate that the quality of such loans will deteriorate substantially in 2007. (Italics added.) Banks were asked the same set of special questions about their outlook for loan quality in the January 2006 survey. A year ago, the net fraction of institutions that anticipated some deterioration in credit quality was notably smaller for loans to both businesses and households.

What are the reasons for the deterioration?  “Demand for commercial real estate loans at [domestic banks] was said to have weakened over the past three months.  ….In the household sector, domestic respondents noted that they tightened credit standard on residential mortgage loans over the survey period, while demand for such loans continued to weaken,” the Fed’s survey states in the first paragraph.

What is the danger from the low quality of bank loans?   It stems from two relatively recent financial innovations, securitization, and sub-prime lending.  The first refers to the repackaging of bank loans and selling them to investment banks and individual investors.  As the quality of the underlying loans falls, the quality of these securities also falls, which, sooner or later, will cause a substantial fall in the price of such securities. Feeding this loan-quality deterioration is the new practice of loans to bad risks, “lemons,” at exotic terms such as interest-only payments.  These fears seem have already begun to materialize, as noted in Friday’s Wall Street Journal.  The Journal also notes that another innovation, “the collateralized debt obligation, or CDO, has made it possible for far more investors to make bets on U.S. mortgages. They are akin to mutual funds. By investing in a single CDO, investors can gain exposure to hundreds of different mortgage securities of varying quality.”

If such fears become widespread, the danger to banking, to financial markets, and the entire economy will be substantial.

An excellent front-page article in today’s Wall Street Journal by Deborah Solomon comparing today’s war economy to the one of the Vietnam period. This article can serve as an update of chapter 28 of our book, Money, Credit and Financial Markets: Theory and Experience. The article’s title alone is a good summary of its content: GUNS AND BUTTER: How War’s Expense Didn’t Strain Economy. Foreign Lending, Lessons from LBJ; How Long will It Last? The accompanying box also summarizes the article:

• The Issue: President Bush has managed to wage a war, cut taxes and boost other spending without triggering Vietnam-era inflation.

• The Background: The spending spree has been aided by foreign borrowing and a strong economy.

• What’s Next: While economically painless so far, war and military spending will soon collide with looming entitlement obligations.

Here is the beginning of the article.

WASHINGTON — Since President Bush took office, he’s boosted annual defense spending by 50% — including $500 billion over five years for fighting in Iraq and Afghanistan — and doubled spending on homeland security. At the same time, he’s cut taxes, expanded Medicare to cover prescription drugs, approved $100 billion to clean up after Gulf Coast hurricanes, and signed bills that spend a little more each year on domestic programs.

For years, critics said it couldn’t last, backed by some historical precedent: President Johnson is blamed by many for triggering inflation in the 1970s by spending on both guns and butter.

But this time, it’s been nearly painless. Inflation is in check. The federal budget deficit is down from its 2004 peak, and rests near its historical average of 2% of gross domestic product, a measure of the nation’s total output. Long-term interest rates are relatively low.

What’s Mr. Bush’s secret? Ingredient one: strong revenue growth driven by an economy distinguished by surging profits and rising incomes at the top, which are taxed more heavily than incomes at the bottom. Ingredient two: tax cuts and spending increases, which arrived when the U.S. economy needed a boost. Ingredient three, and perhaps the most significant: the willingness of foreigners to lend to the U.S., which finances the budget deficit without pushing up interest rates at a time when Americans don’t save very much.

“This situation is what you’d call an exorbitant privilege,” says Menzie Chinn, a University of Wisconsin economist. “We’ve gotten a pretty good deal so far.”

No one knows when this bonanza might end, although end it must. For the coming year, Mr. Bush is expected to shave costs from programs and agencies unconnected to defense. In the future, the flow of cash from foreign lenders could dry up. Health care and Social Security could swamp the federal budget. In the shorter term, the combination of military spending and tax cuts could collide with spending priorities outlined by the capital’s newly empowered Democrats.