SF Fed Head Yellen - An Economic Death Spiral?
SF Fed Head Yellen astutely describes what ails the financial and economic systems.
On lags... While housing construction has been weak for more than two years, its effects did not spill over to most other sectors until fairly recently.
On financial markets... the disruptions in U.S. and global financial markets, these disruptions are likely to continue for some time.
On risk mitigation... it is now apparent that underwriting standards slipped substantially in the United States as house prices soared.
On whats caught in the pipeline... One problem is an unanticipated buildup of mortgages as well as LBO-related loans on their (depository institutions aka banks) balance sheets. These loans were in the pipeline for securitization but could not be sold. The value of these securities and CDOs has fallen dramatically, so banks and other financial institutions have had to write down their values, which has shrunk their capital and driven their stock prices down.
On guarantors and credit losses... the guarantors are reporting sizable losses because of the increased riskiness of the securities they are covering. Those losses can affect the guarantors’ capital positions and even their own credit ratings. A downgrade of a guarantor reduces the value of its credit enhancements and lowers the price of the covered securities. Holders of those securities such as banks then have to take write-downs to reflect the lower value of the securities.
On equity markets... Broad U.S. equity indices have been very volatile, and, on the whole, have declined since August, representing a restraint on spending. This will restrain spending going forward. The impact hit economic activity mainly in the fourth quarter, and so far, it has been starkly negative.
On the economy... Current indicators point to continued anemic growth for at least the first half of this year as well as significant downside risks even to those weak expectations.
On housing... Forward-looking indicators of housing activity strongly suggest that the downward cycle may be with us a while longer. Housing permits and sales are dropping, and inventories of unsold homes are at very high levels. Those inventories could rise even higher as foreclosures continue to mount. We’ve begun to see increases in foreclosures on subprime fixed-rate mortgages and even on prime adjustable-rate mortgages. On the national level, housing construction probably will continue to contract through the end of this year. House prices have fallen noticeably and the declines have intensified. Moreover, futures markets for house prices indicate further—and even larger—declines in a number of metropolitan areas this year.
A grand miscalculation...
It is true that the residential construction sector is a fairly small piece of the overall economy and is unlikely to cause significant overall weakness in and of itself.
(Dammit, Janet!, 80% of all new jobs since 2001 is a fairly large piece... tied into 70% of GDP being consumer spending related.)
On consumer spending... It would not be surprising to see even more moderation (in spending) over the next year or so. With the domestic consumer likely to be pretty hobbled, it is tempting to look at consumers beyond our own borders to be a source of strength for economic activity.
On decoupling... A slowdown here could well produce ripple effects lowering growth there through trade linkages, and recently this factor has been reinforced by a worldwide drop in stock prices.
On employment... Another negative factor for consumption is that labor markets have softened. The overall economy is still likely to turn in a very sluggish performance this year expanding by a rate well below potential and creating more slack in labor markets. The unemployment rate is already slightly above my estimate of its sustainable level. Slow growth this year would most likely push unemployment even higher.
On the lack of CapEx... My comments haven’t even touched on possible slowdowns in business investment in equipment and software and buildings. I see the growth risks as skewed to the downside for the near term.
On a economic death spiral or self perpetuating vortex...
In circumstances like these, we can’t rule out the possibility of getting into an adverse feedback loop that is, the slowing economy weakens financial markets, which induces greater caution by lenders, households, and firms, and which feeds back to even more weakness in economic activity and more caution. Indeed, an important objective of Fed policy is to mitigate the possibility that such a negative feedback loop could develop and take hold….
On lags... While housing construction has been weak for more than two years, its effects did not spill over to most other sectors until fairly recently.
On financial markets... the disruptions in U.S. and global financial markets, these disruptions are likely to continue for some time.
On risk mitigation... it is now apparent that underwriting standards slipped substantially in the United States as house prices soared.
On whats caught in the pipeline... One problem is an unanticipated buildup of mortgages as well as LBO-related loans on their (depository institutions aka banks) balance sheets. These loans were in the pipeline for securitization but could not be sold. The value of these securities and CDOs has fallen dramatically, so banks and other financial institutions have had to write down their values, which has shrunk their capital and driven their stock prices down.
On guarantors and credit losses... the guarantors are reporting sizable losses because of the increased riskiness of the securities they are covering. Those losses can affect the guarantors’ capital positions and even their own credit ratings. A downgrade of a guarantor reduces the value of its credit enhancements and lowers the price of the covered securities. Holders of those securities such as banks then have to take write-downs to reflect the lower value of the securities.
On equity markets... Broad U.S. equity indices have been very volatile, and, on the whole, have declined since August, representing a restraint on spending. This will restrain spending going forward. The impact hit economic activity mainly in the fourth quarter, and so far, it has been starkly negative.
On the economy... Current indicators point to continued anemic growth for at least the first half of this year as well as significant downside risks even to those weak expectations.
On housing... Forward-looking indicators of housing activity strongly suggest that the downward cycle may be with us a while longer. Housing permits and sales are dropping, and inventories of unsold homes are at very high levels. Those inventories could rise even higher as foreclosures continue to mount. We’ve begun to see increases in foreclosures on subprime fixed-rate mortgages and even on prime adjustable-rate mortgages. On the national level, housing construction probably will continue to contract through the end of this year. House prices have fallen noticeably and the declines have intensified. Moreover, futures markets for house prices indicate further—and even larger—declines in a number of metropolitan areas this year.
A grand miscalculation...
It is true that the residential construction sector is a fairly small piece of the overall economy and is unlikely to cause significant overall weakness in and of itself.
(Dammit, Janet!, 80% of all new jobs since 2001 is a fairly large piece... tied into 70% of GDP being consumer spending related.)
On consumer spending... It would not be surprising to see even more moderation (in spending) over the next year or so. With the domestic consumer likely to be pretty hobbled, it is tempting to look at consumers beyond our own borders to be a source of strength for economic activity.
On decoupling... A slowdown here could well produce ripple effects lowering growth there through trade linkages, and recently this factor has been reinforced by a worldwide drop in stock prices.
On employment... Another negative factor for consumption is that labor markets have softened. The overall economy is still likely to turn in a very sluggish performance this year expanding by a rate well below potential and creating more slack in labor markets. The unemployment rate is already slightly above my estimate of its sustainable level. Slow growth this year would most likely push unemployment even higher.
On the lack of CapEx... My comments haven’t even touched on possible slowdowns in business investment in equipment and software and buildings. I see the growth risks as skewed to the downside for the near term.
On a economic death spiral or self perpetuating vortex...
In circumstances like these, we can’t rule out the possibility of getting into an adverse feedback loop that is, the slowing economy weakens financial markets, which induces greater caution by lenders, households, and firms, and which feeds back to even more weakness in economic activity and more caution. Indeed, an important objective of Fed policy is to mitigate the possibility that such a negative feedback loop could develop and take hold….
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