The Federal Reserve cut interest rates in September and October to manage the macroeconomic “tail risks” posed by the slowdown in housing and disruption of financial markets.
But the downside risk to economic growth now appears to be roughly balanced by the upside risk to inflation, Federal Reserve Governor Randall Kroszner told attendees at a financial conference in New York today.
Kroszner said his remarks were his own, and do not necessarily reflect those of his colleagues on the Federal Open Market Committee, which sets the targets for key short-term interest rates, including the federal funds rate and the discount rate.
But if Kroszner’s views are shared by other members of the committee, the Fed may leave interest rates where they are when it meets again Dec. 12.
After ratcheting up the federal funds rate to 5.25 percent at 17 consecutive meetings between 2004 and 2006 to cool the pace of economic growth, the Fed’s Open Market Committee on Sept. 18 slashed the rate by 50 basis points, to 4.75 percent.
That cut, and a subsequent 25-basis-point reduction on Oct. 31, were intended to stimulate borrowing and keep the economy from faltering as the fallout from the housing downturn rippled through financial markets.
Cuts of the same magnitude were applied at both meetings to the discount rate, the rate the Fed charges for direct loans to banks, leaving it at 5 percent.
Mortgage Bankers Association Chief Economist Doug Duncan said last month that the current federal funds rate of 4.5 percent could represent a “neutral” position that allows for moderate economic growth while keeping inflation in check.
Kroszner’s comments are an indication that is how he sees it.
After the Fed’s actions in September and October, “the downside risks to economic growth now appear to be roughly balanced by the upside risks to inflation,” Kroszner said in his prepared remarks. The “limited data and information” he’s seen since the October meeting “have not changed my thinking in this regard.”
The Fed’s current stance on interest rates “should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate,” Kroszner said. “As conditions in mortgage markets gradually normalize, home sales should pick up, and home builders are likely to make progress in reducing their inventory overhang.”
Although some in the housing and lending industry have complained the Fed was too slow to slash interest rates, others have criticized the steps it’s taken so far as a bailout of financial markets at the expense of taxpayers and investors whose assets are in dollars. Cutting the federal funds rate can weaken the dollar and stimulate inflation, which may erode the value of dollar-backed investments and make it more costly for the government to borrow money.
In justifying the Fed’s cuts in short-term interest rates, Kroszner explained his view of the threat the housing downturn poses to the economy.
Early in the summer, losses on securities backed by subprime home mortgages sparked concerns about the performance of a range of securities with exposure to those mortgages, and investors quickly pulled back, he said. With secondary markets under significant strain, a number of large originators announced substantial changes to their subprime-mortgage programs, and the volume of newly issued securities backed by subprime mortgages fell precipitously and stayed low.
The same forces also damped investors’ willingness to fund other types of nonconforming mortgages that do not qualify for sale to Fannie Mae and Freddie Mac, Kroszner said. The issuance of securities backed by “alt-A” loan pools declined markedly. While prime jumbo home-purchase loans continued to be originated, the spread of rates on such loans over those on conforming loans was considerably higher than earlier in the year.
“In terms of the macroeconomic outlook, this substantial tightening in mortgage markets seemed likely to increase the odds of a deeper and more long-lasting contraction in the housing market,” Kroszner said.
The mounting losses from securities backed by subprime mortgages led investors to lose confidence in other structured finance products.
“Once losses began to mount, the earlier lack of due diligence by investors brought them to the realization that they had an insufficient amount of information about these products, and the normal price-discovery mechanism began to break down,” Kroszner said. “The concerns about structured credit products led to severe problems in markets for asset-backed commercial paper, where spreads spiked and programs had difficulty issuing paper with maturities longer than a few days.”
The largest banks began to worry, realizing they might have to provide backup funding to commercial paper programs, and faced “substantial challenges” syndicating the leveraged loans they had underwritten. As a result, Kroszner said, banks became “very protective of their liquidity, and interbank funding markets came under considerable pressure.”
The extent banks were going to in order to protect their liquidity — and the pressures on their balance sheets — “raised in my mind the possibility that banks could tighten lending standards and terms significantly and thereby exert a material drag on economic growth,” Kroszner said.
After the Fed’s September interest-rate cuts, “it was evident that real gross domestic product had grown at a solid pace in the third quarter,” Kroszner said. But the information coming in during the six weeks before the Open Market Committee’s Oct. 31 meetings “suggested an intensification of the housing correction.” Mortgage markets remained “significantly impaired,” Kroszner said, and banks had tightened terms and standards on a range of loans, including mortgages.
The Open Market Committee decided another round of less drastic interest-rate reductions was in order, Kroszner said, because monetary policy was still “somewhat restrictive” given the effects of tighter credit on aggregate demand.
As for the potential inflation costs accompanying that action, the data the Fed was seeing on consumer prices “continued to be encouraging and inflation expectations appeared to remain reasonably well anchored,” Kroszner said.
The recent run-up in energy prices and the dollar’s continuing decline suggest that since the Sept. 18 meeting “somewhat greater inflation risks had raised the costs of easing policy to manage the macroeconomic risks,” Kroszner said. “Nonetheless, on balance, I viewed the benefits of that action as being greater than the costs.”
Kroszner said that each cut in short-term rates is accompanied by “decreasing incremental benefits in terms of further mitigating tail risks and with increasing incremental costs in terms of the potential for inflation to increase. In the current context, I would be especially concerned if inflation expectations were to become unmoored and will watch both market-based and survey-based measures of inflation expectations closely.”
On Wednesday, the Federal Open Market Committee announced that in a move to create greater transparency, it would increase the frequency and expand the content of the economic projections made by Federal Reserve Board members and Reserve Bank presidents.
The committee will release projections of economic growth, unemployment, and inflation on a quarterly basis rather than twice a year, and the projections will look ahead three years instead of two.
Projections made by members of the Board of Governors and presidents of the Federal Reserve Banks will be published with the minutes of the Federal Open Market Committee meetings scheduled for January, April, June and October. Minutes of the committees Oct. 31 meeting will be released Nov. 20.
Fed Chairman Ben Bernanke said the beefed-up reporting will “illuminate both the consensus of opinion and the differences in judgments that may emerge” at the meetings.
