In Part I of this morning's posts on the Federal Reserve, I pointed out that, since World War II, significant housing price drops have always been followed by recessions or been coincident with them.
The Federal Reserve’s initial response to the subprime mortgage crisis was to claim last spring that it seemed likely to be “contained”:
Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency. We will continue to monitor this situation closely.
As unlikely as that seemed to me at the time, I hoped that the experts at the Federal Reserve knew what they were talking about.
When Cerberus was unable to sell its paper to fund the Chrysler deal, the deal went through anyway by extending the bank bridge loans, but the stock market realized that subprime problems had spread to the market for commercial paper and private equity funding. Then it was revealed that the market for mortgage-backed securities was mostly not functioning, which made it difficult for mortgage lenders to raise money by selling off their existing mortgages. High-flying hedge funds and European banks started revealing problems. Unlike in downturns earlier in the year when precious metals, oil, and basic materials stocks tended to rally, in recent downturns harder assets (and stocks reflecting them) started doing poorly as well.
In the face of a credit crunch that was clearly not being contained, nine days ago the Federal Reserve released its decision on interest rates:
Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy. Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures. Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.
Frankly, I was surprised.
Data released in the last few weeks suggest that US inflation is moderating (running only 2.2% year over year) and job growth is slightly softer than expected, giving the Fed plenty of room to lower interest rates. Seemingly informed commentators report that dozens of European and Asian banks probably have nontrivial amounts of subprime paper in their portfolios. The commercial paper market is so frightened that concerns have been raised about whether money market funds can maintain their $1 asset value. Although most commentators say that they will be able to do so, many institutions are reported to be dumping even quality commercial paper in favor of treasury bills and notes in a flight to quality.
It would seem that with housing prices falling, commodity prices falling, stock prices falling, commercial paper prices falling, and CDO prices collapsing, net deflation (rather than inflation) would seem to be the bigger risk. And, of course, the author of the leading policy paper on deflation is none other than Federal Reserve Chair, Ben Bernanke (2002, discussed in Part IV posted below).
In my genuine ignorance, it seemed to me that, even if the Federal Reserve Board had acted promptly in late July or at its August meeting last Tuesday, avoiding a US recession (or a near recession) would be a tough task for the Fed. In a global economy, the Fed has much less control than it used to. By deciding to wait until the subprime mess degrades not only the inputs for economic growth, but economic growth itself, the Fed may decrease the chances that it will ultimately succeed.
Next: The Fed, Part III: Poole Says `Real Economy' Unhurt by Subprime Collapse.
Related Posts (on one page):
1.) A collapse in one sector of the economy (and the drop in prices in that sector as part of the collapse) is not at all the same as "deflation." And you can very much have a stagnant economy that's also facing heavy inflation (hence "stagflation," usually caused by a negative supply shock). In fact, other sectors are showing significant inflation, such as the food prices (see, e.g., http://www.mcclatchydc.com/227/story/18902.html?source=rss).
The Fed's public statements recently have been explicit that the Fed is still concerned about inflation (the NYT had an article on this this morning: http://www.nytimes.com/2007/08/16/business/16econ.html). So while Bernanke certainly is an expert on what to do when faced with the prospect of deflation, you don't see him taking those measures because he doesn't believe deflation is an issue right now; rather, he's still concerned about excessive inflation.
2.) The reason why we have an independent central bank is to solve commitment problems that arise when our short-term interests are inconsistent with our long-term goals. It's hard to think of any better illustration of that problem than the current crisis with sub-prime loans: the lenders knew that these loans weren't likely to pay off, but they went ahead anyway, perhaps betting that we'd have to bail them out later. And sure enough, right now there's strong pressure to bail them out to avoid the havoc that will arise if these loans fall through. On the other hand, we can't signal that every time lenders go crazy and start making bad loans we'll bail them out, or else they'll have no incentive to be responsible in their lending. Hence there's a ton of immediate pressure on the Fed right now to bail us out, but in the long run a bail-out might undermine economic activity far more than a recession now. It's a perfect illustration of the moral hazard problem.
There's no magic solution here. Lenders went ahead and knowingly made a bunch of bad loans; hedge funds and others knowingly traded in these bad loans; and now there are going to have to be consequences. It seems that a bit of a recession is exactly what we need right now, like it or not (and it could be a nasty one: a collapse in the mortgage market = a major slowdown in the housing market = major slowdown and layoffs in construction and all sorts of other markets that revolve around housing, which have been responsible for a LOT of employment in recent years).
I suspect that Bernanke knows very well that lowering the interest rate would help alleviate the serious threat of recession that we're facing, but refuses to do so because bailing out the lenders would cause far, far more damage in the long run. He may be knowingly steering us into a recession right now, politically unpalatable though it may be (that's why the Fed is independent), because in the present circumstances allowing a recession is actually the right thing to do.
Jim Lindgren
That leaves the question of what causes what, if anything. Logically, one would expect the housing market to be particularly sensitive to consumer confidence, which, in turn, is one of the causes of a recession.