The two things I heard from Ben Bernanke’s testimony before the Joint Economic Committee yesterday: stagflation and stupidity.
Mr. Bernanke’s testimony started out OK:
“On preliminary estimates, real gross domestic product (GDP) grew at an average pace of nearly 4 percent over the second and third quarters despite the ongoing correction in the housing market. Core inflation has improved modestly, although recent increases in energy prices will likely lead overall inflation to rise for a time.”
OK, 4% GDP growth with a little inflation pressure, not bad. Sounds like there should be a neutral policy with maybe a slight bias toward a rate hike. Not so fast. There’s a bit of trouble afoot in the credit markets. The Chairman acknowledged that investors got a lot of the risk calculation wrong on many financial instruments. He said “At one time, most mortgages were originated and held by depository institutions. Today, however, mortgages are commonly bundled together into mortgage-backed securities or structured credit products, rated by credit-rating agencies, and then sold to investors. As mortgage losses have mounted, investors have questioned the reliability of credit ratings, especially those of structured products.” (I hope Senator Schumer was listening to the part about the rating agencies as that point was absent from his report on the subprime mess – see my commentary for more on that.) The impact of this has not yet run its course.
“To be sure, the recent developments may well lead to a healthier financial system in the medium to long term: Increased investor scrutiny of structured credit products is likely to lead ultimately to greater transparency in these products and to better differentiation among assets of varying quality. Investors have also become more cautious and are demanding greater compensation for bearing risk. In the short term, however, these events do imply a greater measure of financial restraint on economic growth as credit becomes more expensive and difficult to obtain.”
In other words, the credit market issues are only beginning to spill over into the broader market, and the “short term” impact will be slower economic growth. He later made some comments that would suggest his estimate of short term is the spring of 2008, but he did not have much conviction on that point.
The Chairman then went on to review FED actions over the past few months leading up to the October meeting, including the injection of excess reserves into the system and 50 basis point reduction of the discount rate in August, and the September 50 basis point cut in the federal funds rate and discount rate. Then came the reasoning behind the 25 basis point rate cut in October (which I thought was a mistake).
“Looking forward, however, the Committee did not see the recent growth performance as likely to be sustained in the near term. Financial conditions had improved somewhat after the September FOMC action, but the market for nonconforming mortgages remained significantly impaired, and survey information suggested that banks had tightened terms and standards for a range of credit products over recent months. In part because of the reduced availability of mortgage credit, the contraction in housing-related activity seemed likely to intensify. Indicators of overall consumer sentiment suggested that household spending would grow more slowly, a reading consistent with the expected effects of higher energy prices, tighter credit, and continuing weakness in housing. Most businesses appeared to enjoy relatively good access to credit, but heightened uncertainty about economic prospects could lead business spending to decelerate as well. Overall, the Committee expected that the growth of economic activity would slow noticeably in the fourth quarter from its third-quarter rate. Growth was seen as remaining sluggish during the first part of next year, then strengthening as the effects of tighter credit and the housing correction began to wane.”
So, in the committee’s judgment, there is downside risk to the economy and, in fact, every expectation that economic growth will be anemic for the next couple of quarters. In addition to the outlook, however, there is also downside risk that could make things worse. “One such risk was that financial market conditions would fail to improve or even worsen, causing credit conditions to become even more restrictive than expected. Another risk was that, in light of the problems in mortgage markets and the large inventories of unsold homes, house prices might weaken more than expected, which could further reduce consumers' willingness to spend and increase investors' concerns about mortgage credit.” This is recession speak in my view. If the expectation is already for weak economic growth, worse than that likely means contraction. So we see some real concern here about the economy from the FED leading up to the October rate cut. So absent inflation concerns, the accepted strategy would be a rate cut. Lets look at what he had to say about inflation.
“The Committee projected overall and core inflation to be in a range consistent with price stability next year. Supporting this view were modest improvements in core inflation over the course of the year, inflation expectations that appeared reasonably well anchored, and futures quotes suggesting that investors saw food and energy prices coming off their recent peaks next year. But the inflation outlook was also seen as subject to important upside risks. In particular, prices of crude oil and other commodities had increased sharply in recent weeks, and the foreign exchange value of the dollar had weakened. These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well.” Sounds like there is some upside risk to inflation here as well, so maybe a rate cut is a bit risky? Here is what the Chairman said about it:
“Weighing its projections for growth and inflation, as well as the risks to those projections, the FOMC on October 31 reduced its target for the federal funds rate an additional 25 basis points, to 4-1/2 percent. In the Committee's judgment, the cumulative easing of policy over the past two months should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time. Nonetheless, the Committee recognized that risks remained to both of its statutory objectives of maximum employment and price stability. [emphasis added] All told, it was the judgment of the FOMC that, after its action on October 31, the stance of monetary policy roughly balanced the upside risks to inflation and the downside risks to growth.”
In other words, at the time of the rate cut there were risks that economic growth could slow significantly, and that inflation could become a problem. What has happened since the October 31 rate cut decision (only 8 days prior to the testimony)? According to the Chairman:
“In the days since the October FOMC meeting, the few data releases that have become available have continued to suggest that the overall economy remained resilient in recent months. However, financial market volatility and strains have persisted. Incoming information on the performance of mortgage-related assets has intensified investors' concerns about credit market developments and the implications of the downturn in the housing market for economic growth. In addition, further sharp increases in crude oil prices have put renewed upward pressure on inflation and may impose further restraint on economic activity. [emphasis added]”
There it is – stagflation. Slower economic growth AND inflation equals stagflation. Now, the Chairman did not say we are experiencing stagflation. If inflation does get worse, that could be because the economy continues to grow. If growth suffers, that could limit inflationary pressures. But both of those possible outcomes are now clouded by the specter of both slowing economic growth and inflation, or stagflation, because of rising oil prices plus the pressure on the dollar and its impact on prices of imported goods. The inflationary impact of the dollar decline is somewhat muted by our trade imbalance with China because the exchange rates of the currencies are manipulated, but I hate to count on that for economic security in the US. Ron Paul summed up the negative outlook by pointing out that so long as we inflate our way out of excess consumption the dollar will decline leading to inflation, and given the lose monetary policy of the recent past we are now without options to fight either inflation or slow economic growth unless we align consumption with output – i.e. recession. This is the Senators way of saying the credit binge must end somewhere, and it may just be here. That would mean that the FED is stuck between the proverbial rock and hard place. If it follows an expansionary policy of lower rates inflation could spiral up, and if it follows a contractionary policy to contain inflation it could depress an already shaky economy. What did Mr. Bernanke have to say about all of this?
“The FOMC will continue to carefully assess the implications for the outlook of the incoming economic data and financial market developments and will act as needed to foster price stability and sustainable economic growth.” Is it time to redefine “price stability” and “sustainable economic growth”? Maybe it is. For now we are “data dependent.”
Every now and again I here a stupid idea thrown about or I read a “report” to some congressional committee that makes no sense. I don’t mean an idea that just sounds different. I mean one that you hear with disbelief followed by a realization that you actually did hear what you thought you heard. You expect it once in a while, but when it comes directly from elected officials and their appointees, it takes on a whole different character.
Yesterday I witnessed an exchange between Senator Schumer and Ben Bernanke before the Joint Economic Committee of Congress. Senator Schumer pressed Mr. Bernanke on ways in which Congress could help the mortgage market, and whether increasing the caps on the size of mortgages that Fannie Mae and Freddie Mac can make (currently $417,000.00) would be helpful. Mr. Bernanke went on to say that the caps could be increased to $1 million per loan, and that to reduce the risk to Fannie Mae and Freddie Mac from this increased exposure, the federal government could guarantee those loans. That’s right, you read that correctly. The government sponsored entities set up to help expand affordable homeownership should be used as vehicles to make mortgages of up to $1,000,000.00, and your tax dollars should guarantee those mortgages. I almost broke the television set when I heard it. If you need verification, you can read about it in The WSJ Online Edition.
(I was going to forget about this whole exchange until it gained some validity through publication of this WSJ article.)
Lets start with the missions of Fannie Mae and Freddie Mac. First from Fannie: “Fannie Mae is a shareholder-owned company with a public mission. We exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market.
And here is Freddie Mac:
“Our mission strives to create:
· Stability: Freddie Mac's retained portfolio plays an important role in making sure there’s a stable supply of money for lenders to make the home loans new homebuyers need and an available supply of workforce housing in our communities.
· Affordability: Financing housing for low- and moderate-income families has been a key part of Freddie Mac’s business since we opened our doors. Freddie Mac’s vision is that families must be able both to afford to purchase a home and to keep that home.
· Opportunity: Freddie Mac makes sure there's a stable supply of money for lenders to make the loans new homebuyers need. This gives everyone better access to home financing, raising the roof on homeownership opportunity in America.”
In short, these entities exist to “expand affordable housing” by providing a “supply of money for lenders to make the home loans new homebuyers need and an available supply of workforce housing,” and “Financing housing for low-and moderate-income families” and “new homebuyers.”
Just what is “affordable housing?” Here is what The Department of Housing and Urban Development has to say about it: “The generally accepted definition of affordability is for a household to pay no more than 30 percent of its annual income on housing. Families who pay more than 30 percent of their income for housing are considered cost burdened and may have difficulty affording necessities such as food, clothing, transportation and medical care. An estimated 12 million renter and homeowner households now pay more then 50 percent of their annual incomes for housing, and a family with one full-time worker earning the minimum wage cannot afford the local fair-market rent for a two-bedroom apartment anywhere in the United States. The lack of affordable housing is a significant hardship for low-income households preventing them from meeting their other basic needs, such as nutrition and healthcare, or saving for their future and that of their families.”
Nope, doesn’t sound like a homebuyer with a $1 million mortgage to me.
What is “workforce housing”? According to Wikipidia, “Workforce housing is a relatively new term that is increasingly popular among planners, government administrators and housing activists, and is gaining cachet with home builders, developers and lenders. ‘Workforce housing’ can refer to almost any housing, but always refers to ‘affordable housing’.”
Nope, that doesn’t sound like a homebuyer with a $1 million mortgage either.
What are low- and moderate-incomes? Whatever they are, they are not applicable to the purchaser of a home with a mortgage of $1 million. I don’t even need to look that one up!
Mr. Bernanke is generally a very reasonable person in my view, although I disagree with FED action on occasion. In light of this, I decided to look up more about his position on Fannie and Freddie going outside the scope of their missions to provide mortgage financing for people purchasing homes in the $1 million range (actually with a mortgage of $1 million the purchase price could be as high as $1,250,000 at 80% loan-to-value). Here is what I found from a March 6, 2007 MSNBC report: “Federal Reserve Chairman Ben Bernanke urged Congress on Tuesday to bolster regulation of mortgage giants Fannie Mae and Freddie Mac, and suggested limiting their massive holdings to guard against any danger their debt poses to the overall economy.
“Bernanke has previously supported efforts to pare the two mortgage companies’ huge portfolios. This time, however, he was a bit more specific and recommended that their holdings might be linked to a ‘measurable public purpose, such as the promotion of affordable housing.’”
There is that phrase again – affordable housing. I wonder what caused Mr. Bernanke to do a complete about face on this issue between March and November from affordable housing only to non-conforming loans up to $1 million. I suppose if taxpayers guaranteed these $1 million loans they would not pose any additional danger to the overall economy (at least not immediately).
Now I must preface the balance of this piece with a thought about Senator Schumer. I always liked him and, it seems funny now, I have heard other people say the same thing about him. He is likeable. But since I started writing about issues of policy and economics, I have discovered that Senator Schumer shows up on the wrong side of many issues (that would be the side opposite mine). (I have written about such issues twice before here and here.) This is another good example because it appears Senator Schumer and Chairman Bernanke are concerned about the mortgage crises fall out on people with mortgages and homes valued at $1 million and more. This seems to be a little out of place given the current housing market crises impact on lower- and middle-income families. In addition to this incongruous line of thinking is the plainly stupid idea that the federal government should be guaranteeing mortgages in the $1 million range. Of course this leads me to the inevitable question – where do I apply!
I am against any taxpayer bailout of mortgagors who bit off more than they could chew. If you would like to read my opinion on this topic and my reasons for it you can see my post from October on that subject here. I am absolutely against any taxpayer guarantee of mortgages on non-conforming loans anywhere near the $1 million mark. In fact, I am dumbfounded by that entire exchange unless it was meant to soften us up for some other bailout proposal. At this moment in time, with two wars, a $9 trillion national debt, a falling dollar, inflation concerns, and tightening credit I believe there are much more important things to do with the credit of the American taxpayer than to put it behind purchases of $1 million homes. Focusing help on the wealthiest among us at a time when income distribution is coalescing at the top and raising taxes on high income is met with staunch criticism is indicative of a government that is completely out of touch. I am also concerned about the future unintended consequences that could result from this type of market manipulation and the distortions that it would create.
I am left hoping that Chairman Bernanke was not serious in his comments and/or Senator Schumer dismissed the concept out of hand. Unfortunately I have become a bit cynical in these times of mortgage meltdown and wealth transfers, and I fear there is a legislative proposal being prepared right now by one of Senator Schumer’s aids. I hope my fears prove unfounded.
Friday, November 9, 2007
The two things I heard from Ben Bernanke’s testimony before the Joint Economic Committee yesterday: stagflation and stupidity.