Wednesday, October 8, 2008

Fed Chairman Bernanke's Financial Crisis Speech

He addresses among other topics the problems created by badly designed economic incentives in our mortgage system. Here are some among the main points in his speech:
... On the heels of nearly a year of stress in credit markets, investors’ and creditors’ concerns about funding and credit risks at financial firms intensified over the summer as mortgage-related assets deteriorated further, economic growth slowed, and uncertainty about the economic outlook increased. As investors and creditors lost confidence in the ability of certain firms to meet their obligations, their access to capital markets as well as to short-term funding markets became increasingly impaired and their stock prices fell sharply. ...

The Federal Reserve believes that, whenever possible, such difficulties should be addressed through private-sector arrangements ... Government assistance should be provided with the greatest reluctance and only when the stability of the financial system, and thus the health of the broader economy, is at risk. In those cases when financial stability is threatened, however, intervention to protect the public interest may well be justified.

Fannie Mae and Freddie Mac present cases in point. The Federal Reserve had long warned about the systemic risks posed by these companies’ large portfolios of mortgages and mortgage-backed securities, as well as the problems arising from the conflict between shareholders’ objectives and the government’s goals for the two firms. ...

... Equity prices have fallen sharply, the cost of short-term credit, where such credit has been available, has spiked, and liquidity has dried up in many markets. ... At the same time, a marked increase in the demand for safe assets–a flight to quality and liquidity–resulted in a further drop in the value of mortgage-related assets and sent the yield on Treasury bills down to a few hundredths of a percent.

All told, economic activity is likely to be subdued during the remainder of this year and into next year. The heightened financial turmoil that we have experienced of late may well lengthen the period of weak economic performance and further increase the risks to growth. To support growth and reduce the downside risks, continued efforts to stabilize the financial markets are essential. The Federal Reserve will continue to use the tools at its disposal to improve market functioning and liquidity.

Inflation has been elevated ... . However, more recently, the prices of oil and other commodities, while remaining quite volatile, have fallen from their peaks, and prices of imports show signs of decelerating. ... Still, the inflation outlook remains highly uncertain, in part because of the extraordinary volatility of commodity prices. We will need to continue to monitor price developments closely.

Overall, the combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased. At the same time, the outlook for inflation has improved somewhat, though it remains uncertain. In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate.

... The Secretary of the Treasury, with the support of the Federal Reserve, went to the Congress to ask for a substantial program aimed at stabilizing our financial markets. ... Notably, the legislation establishes a new Troubled Asset Relief Program, or TARP, under which the Treasury is authorized to purchase as much as $700billion of troubled mortgages, mortgage-related securities, and other financial instruments from financial firms that are regulated under U.S. law and have significant operations in the United States. The act also raises the limit on deposit insurance at banks and credit unions from $100,000 to $250,000 per account, a step that should reinforce depositors’ confidence in the security of their funds and thus help to stabilize depository institutions. And, as I mentioned, the act provides the Federal Reserve the authority to pay interest on reserves, which will allow us to better manage the federal funds rate as we provide liquidity to the markets. We will begin exercising that authority this week.

... I believe that the bold actions taken by the Congress, the Treasury, the Federal Reserve, and other agencies, together with the natural recuperative powers of the financial markets, will lay the groundwork for financial and economic recovery.

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