Monday, September 10, 2007
Business comment by Richard Jeffrey
Last week, the Bank of England took steps to ease some of the tension in the money markets. In explaining its action, it stated that "these measures are not intended, nor can be expected, to narrow the spreads between anticipated policy rates and the rates at which commercial banks can borrow from each other at longer maturities (for example, the 3-month interbank rate)".In other words, it has no intention of taking action to force down medium-term lending rates, currently substantially above Bank Rate, or to bail out other banks and financial institutions that have made poor investment and lending decisions.
There is a temptation to assume that the current problems in the world's financial markets are merely the reflection of the impact that higher interest rates and slower growth in the US have had on the sub-prime market (and associated financial instruments). However, this is only the immediate cause. The real issue goes further back: why was there such huge sub-prime lending in the first place?
The financial markets hold central banks and bankers in great esteem. Most revered in recent times was Alan Greenspan, chairman of the US Federal Reserve between 1987 and 2006. He could move markets with an intake of breath and wrote his speeches, apparently, while soaking in a hot bath. He not only understood policy, but also had a deep empathy with financial markets. It seemed he could do no wrong.
Sadly, the current state of financial markets, and the problems facing some sectors of the US economy (most obviously the property sector) are Mr Greenspan's direct legacy. There were, of course, macro and financial concerns that prompted Mr Greenspan into setting the Fed Funds target rate at 3pc or less between September 2001 and June 2005 (and at just 1pc between June 2003 and June 2004). However, the policy response to the various issues amounted to a massive over-reaction (and appeasement of financial markets).
The UK authorities are not blameless. Here, there has also been a substantial rise in household indebtedness, encouraged by a policy regime that saw interest rates below 5pc between September 2001 and October 2006 and at 4pc or below between November 2001 and April 2004. In both the US and the UK, this inevitably sucked in large numbers of higher-risk borrowers. In the UK, a large part of the problem resulted from the policy framework set up by the Treasury. No one would deny that in normal circumstances low inflation is a sensible policy criterion. However, to make inflation the sole determinant of policy in a highly complex economy is inherently risky. The target itself is arbitrary, and structured according to how we perceive the economy has behaved in the past. It is not a range, as some believe, but a single point: 2pc. Although the Treasury can argue that the Bank of England's remit does give it a degree of flexibility, in practice current and forecast inflation dominates policy decisions.
Unfortunately, when the target was constructed, it was not envisaged there would be such substantial downwards pressure on the price level resulting from the opening up of China, India and other newly industrialising countries as major low-cost production centres. The result was the Bank of England's Monetary Policy Committee found itself more than once cutting interest rates with the express objective of forcing up the rate of inflation.
The consequence was domestic demand surged and house prices soared as households took on more and more debt. The most obvious symptom of what in earlier times would have been called overheating was an expanding trade deficit. Domestic demand grew much faster than the output potential of the economy, and the gap between exports and imports became the widest in our history.
Ironically, though headline measures of inflation looked satisfactory, it quickly became evident this was due to falling import prices. Domestically generated inflation did not fall, but remained considerably higher than the inflation target. What is more, it remains higher, and is a reminder we have not been as successful in reducing core inflation in the economy as headline numbers might indicate.
One indication of this is the inflation rate for all services products in the Consumer Price Index is running at 3.5pc (compared to an inflation target of 2pc). This is the same rate as has been recorded, on average, since the MPC was set up in 1997.
One of the greatest attractions of the inflation target is its simplicity. But that is also what makes it so dangerous. It has encouraged policymakers, economics commentators and financial markets to develop one-track minds, and ignore obvious signs that growth was becoming unbalanced. The implication was, if inflation was on target, all must be well. In reality, inflation should have been much lower between 1999 and 2005 - the UK would now be far more competitive, and have achieved far greater balance of growth in the economy.
Policy swings in Britain have not been as great as those in the US, and the problems that face us are of lesser magnitude. But the exceptionally high levels of household debt mean the UK could easily find itself in its own debt trap. Whereas in the US it seems the consequences will be confined largely to the financial markets, in the UK, the real economy could be much more vulnerable.
The naïve focus on inflation as the sole determinant of policy should be replaced by a broader remit that includes inflation. The objective should be to achieve a balanced, non-inflationary growth profile.
Richard Jeffrey is chief economist at Ingenious Securities
Yellen Sees `Significant' Pressure on U.S. Economy
By Scott Lanman and Vivien Lou Chen
Sept. 10 (Bloomberg) -- Federal Reserve Bank of San Francisco President Janet Yellen said the U.S. economy is under ``downward pressure'' from the turmoil in credit and housing markets.
``It is critical to take a forward-looking approach -- gauging the effects of recent developments on the outlook, and, importantly, the risks to that outlook,'' Yellen said in a speech to a conference in San Francisco. Declining home prices and rising unemployment may cause ``significant'' risks to consumer spending, she said.
Yellen noted that investors increased bets that the Fed will reduce interest rates next week, with at least 0.75 percentage point of cuts by year-end. In a speech earlier today, Atlanta Fed President Dennis Lockhart declined to repeat remarks he made just four days ago that there weren't ``conclusive'' signs of economic weakness.
``I see significant downward pressure based on recent data indicating further weakening in the housing sector and the tightening of financial markets,'' Yellen said at the annual meeting of the National Association for Business Economics. Higher interest rates and ``tighter terms'' on home loans may also lead to cutbacks in consumer spending, she said.
Economists and investors expect the Federal Open Market Committee to lower its main interest rate by at least a quarter- percentage point from 5.25 percent when policy makers meet Sept. 18. Yellen, who doesn't vote on rates this year, said recent data ``tell us less about the appropriate stance of policy than they normally would'' and that officials must judge how financial developments affect employment, output, and inflation.
After the Fed on Aug. 7 said inflation was still its ``predominant'' concern, the central bank revised its outlook on Aug. 17 to say that economic risks had risen ``appreciably.'' That assessment ``apparently is similar to that of market participants,'' Yellen said in her first speech on the economic outlook in almost two months.
``Investors' perceptions of increased downside risks have resulted in a notable decline in the rates on federal funds futures contracts and their counterparts abroad,'' she said.
Employers cut 4,000 workers in August, the Labor Department said Sept. 7. None of the 88 economists surveyed by Bloomberg News had predicted a decline. Revised figures showed that 69,000 jobs were added to payrolls in June, down from 188,000 in May. In July, employers added 68,000 workers.
Philadelphia Fed President Charles Plosser expressed skepticism two days ago. He said in an interview that he hadn't made up his mind. ``We want to be careful not to overweight one piece of information,'' Plosser said after a speech in Waikoloa, Hawaii, on Sept. 8.
Yellen said the Fed's efforts to pump cash into the banking system and ease the rate and terms on direct loans to banks have been ``helpful'' though not a ``panacea.''
Still, market turmoil sometimes has little effect on the economy, Yellen cautioned. In 1998, when forecasters feared the implications of a Russian debt default and the Fed lowered rates three times, ``growth turned out to be robust,'' she said.
In addition, recent data on manufacturing and capital-goods orders are ``upbeat,'' and business spending on equipment and software ``promises to be a bright spot,'' Yellen said.
``It appears that financing for capital spending for most firms remains readily available on terms that have been little affected by the recent financial turmoil,'' she said in her speech. ``Of course, the outlook for capital spending could worsen if business confidence were shaken.''
The end of the home-price boom may have helped spark the financial turmoil, she said in response to an audience question. ``Even before the events of recent weeks, it was clear that the housing market was weakening'' and ``had weakened substantially,'' Yellen said.
``It takes a long time before housing prices'' adjust, Yellen said, because home sellers are ``very loath to accept lower prices.''
On inflation, Yellen said she sees ``signs of improvement'' in price pressures from recent data. Unlike Lockhart, Yellen didn't express concern about ensuring a ``sustained'' moderation in inflation.
The Fed's preferred price gauge, which excludes food and energy costs, rose 1.9 percent from a year earlier in June and July, within the 1 percent to 2 percent comfort range stated by Yellen and several other officials.
Yellen, 61, hasn't dissented from a decision since becoming San Francisco Fed president in 2004, nor during her 1994-97 stint as a Fed governor in Washington. She was previously an economics professor at the University of California at Berkeley and also served as chairman of President Bill Clinton's Council of Economic Advisers.
Dallas Fed President Richard Fisher and Fed Governor Frederic Mishkin are also scheduled to speak today.To contact the reporter on this story: Scott Lanman in Washington
Fed's Yellen: turmoil adds to risk for economy
Monday September 10, 1:29 pm ET
By Ros Krasny SAN FRANCISCO (Reuters) - San Francisco Federal Reserve Bank President Janet Yellen said on Monday that the current turmoil in financial markets has added "appreciably" to downside risks for the U.S. economy.
"Financial market turmoil seems likely to intensify the downturn in housing," and pose a risk to broader economy, especially consumer spending, Yellen said in a speech at the National Association of Business Economics annual meeting.
Still, Yellen said the goals of price stability and full employment must be the "unswerving focus" of policy-makers. "Monetary policy should not be used to shield investors from losses."
Yellen is not a voting member of the central bank's Federal Open Market Committee in 2007.
She said that declining home prices could hurt consumer spending, and that risks to economic growth would be "significant" if housing prices fall in the context of rising unemployment.
"The key point is that ... a drop in house prices is likely to restrain consumer spending to some extent," Yellen said.
The Fed's actions to shore up the credit markets so far have been "helpful" but not a panacea, Yellen said.
Ultimately, the bank must consider the role of lags in making any policy adjustment, she said. "It is critical to take a forward-looking approach."
Financial markets look for the FOMC to lower its target fed funds rate this month to 4.75 percent from 5.25 percent, where the rate has been since June 2006.
Yellen did not directly address the rate outlook, but referenced an updated FOMC statement made on Aug 17 that discussed increased risks to growth.
"This assessment apparently is similar to that of market participants," Yellen said, noting the decline in the implied fed funds rate shown in interest rate futures markets.
Yellen it was still possible that ultimately, the fallout from the credit market crisis could turn out to be small and that the market could be returning to more normal risk pricing.
"Keeping a cool head" is advisable, she said, while allowing that "the transition from one regime to another can be quite painful."
Yellen said that improvement in inflation pressures has been evident recently, and that core inflation was likely to edge down "slightly" in the next few years.
Washington Mutual sees "perfect storm" in housing
Monday September 10, 11:08 pm ET
By Jonathan Stempel
NEW YORK (Reuters) - Washington Mutual Inc (NYSE:WM - News) said on Monday that most U.S. housing markets are weakening, creating a "near perfect storm" that may force the largest U.S. savings and loan to set aside more money for bad loans.
Chief Executive Kerry Killinger said the thrift may set aside $500 million more for loan losses than the $1.5 billion to $1.7 billion it had forecast in July. Any increase would be Washington Mutual's fourth this year.
Speaking at a Lehman Brothers Inc. financial services conference, Killinger said the housing market faces rising delinquencies and foreclosures, higher borrowing costs, tighter underwriting standards and tough capital markets, "creating what we call a near-perfect storm for housing.
"Most housing markets appear to be weakening, to us," Killinger said. "We would not be surprised to see declines in housing prices in many regions of the country ... for the next few quarters." He said corrections in the housing and credit markets will last longer than the thrift expected.
Seattle-based Washington Mutual has fallen to sixth in U.S. mortgage lending from third in 2005, after it stopped making some riskier loans and in 2006 eliminated nearly 11,000 jobs, or 18 percent of its work force.
Mortgage volume totaled $83 billion from January to June, according to the newsletter Inside Mortgage Finance.
Killinger nevertheless said Washington Mutual is well positioned to benefit, as "weaker competitors close down or finally 'fess up."
Dozens of mortgage lenders have reduced lending or quit the industry this year. More than 50,000 jobs have been eliminated, including up to 12,000 announced on Friday by Countrywide Financial Corp (NYSE:CFC - News), the largest mortgage lender.
Washington Mutual plans to hold more loans for investment, citing potential for strong risk-adjusted returns.
It also plans to move some "nonconforming" loans, which don't meet Fannie Mae (NYSE:FNM - News) and Freddie Mac (NYSE:FRE - News) purchase requirements, to loans held for investment from loans held for sale.
This will result in a third-quarter loss from that activity, Killinger said, as investors resist buying many nonconforming loans. Washington Mutual's home loans unit lost $150 million from January to June.
Washington Mutual shares fell $1.05, or 3 percent, to $33.97 in morning trading on the New York Stock Exchange. Through Friday, they have fallen 32 percent this year.