Frederic S. Miskin, member of the Federal Reserve Board of Governors gave a speech Friday discussing the financial instability of our nation and the reasoning behind actions that the Federal Reserve has taken both historically and recently.

Miskin explained e responsibility of the Federal Reserve in response to financial instability. He says, “The interest of the Federal Reserve in financial stability does not arise out of a concern for the functioning of financial markets as such or out of a desire to aid distressed investors or institutions. Rather, the Federal Reserve vigorously promotes financial stability because of the intimate connection between a stable financial system and solid macroeconomic performance. The financial system, comprising financial markets and institutions, channels funds to those individuals or firms that have productive investment opportunities.”

According to Governor Mishkin, there are four main ‘shocks’ that can at as ‘catalysts’ in financial instability.

• sharp increases in interest rates
• the deteriorating of corporate and household balance sheets
• weakened financial intermediaries
• problems in the banking sector

“Central banks typically inject liquidity into the system via the banking sector, but the intent is clearly to have the liquidity spread from there…injections of liquidity have the potential to directly address the causes of financial instability and therefore to counteract the pernicious effects of financial instability on broad macroeconomic conditions.”

He went on to discuss financial crisis in the past mentioning issues including the Panic of 1907 and the Stock Market Crash of 1987. He cited methods and examples of the efforts of the Federal Reserve to provide liquidity to the financial system.

While discussing the financial instability that currently faces our nation, Governor Mishkin stated, “Although the provision of liquidity is undoubtedly a useful tool, it is not without potential costs.” He went on to explain that this type of action might create and incentive for banks to increase the amount of investment risks that they are willing to take on. If similar actions are improperly handled, it can lead to further financial instability. The Federal Deposit Insurance Corporation Improvement Act of 1991 limits the lending ability of the Federal Reserve to troubled banks to keep that kind of moral hazard from occurring.

With all of that said, there is still a 50/50 chance that there will be another rate cut this week. The FOMC meets at the end of this month and investors and economists are still wondering what the Federal Reserve will do next. Is this speech a foreshadowing of another drop in rates as a move of the Reserve to increase financial stability? Or is Governor Mishkin saying that further moves to help the troubled markets at this time would cause moral hazard? In just a few more days we shall see if there will be any further moves.

Have you ever heard of the Beige Book? It is a report that is compiled based on data from each of the twelve Federal Reserve Banks. The current economic conditions of each district are gathered from a variety of local sources, such as market experts, key business contacts, and economists. The report is published eight times a year. Each time, one Federal Reserve Bank is responsible for collecting all of the data and publishing the report (on a rotating basis). This issue of the Beige Book (released on October 17, 2007) was prepared at the Federal Reserve Bank of Dallas.

Here are some highlights from the report:

While some retail sales increased, growth in consumer spending softened slightly. Department and discount stores, furniture stores, and apparel stores showed a weakening in sales, while electronics and luxury sales remained solid.

Manufacturing growth has dampened due to the declining in the output of products used in home construction. Strong growth was otherwise reported for other materials such as paper, agricultural machinery, and health related equipment.

It is no surprise that real estate is still doing poorly. High inventory of unsold new homes remains, declines in home sales continued, and builders have lessened the construction on new residential property. The commercial property market remained stable, and Manhattan showed a sizable increase in office space rental. Rental rates across the country for business use were stable with some increase.

There continues to be difficulty in the banking and financing market as delinquencies increase. Lenders have tightened credit standards, and consumer lending grew slowly. Mortgages, equity lines and refinancing declined across the districts.

Most of the country has experienced above average crop yields due to favorable weather conditions. The demand for agricultural goods remained high. Several areas experienced some difficulties due to drought, including Alabama, Kentucky, and Virginia.

The labor market is relatively tight. Temporary staffing firms reported increases in hiring. Low-skilled, entry-level workers are in short supply, particularly in retail and hospitality industries.

Energy and raw material costs are high overall. Declines in the dollar value along with high shipping costs have raised the cost of imports. Prices are lower in the cost of vehicles, wood, and some metals.

Critics complain about the ambiguity of the economic outlook. The mixture of positive and negative news leaves it unclear as to whether or not rates will be cut further. With continued economic uncertainty in several aspects of the outlook, it is anyone’s guess as to what action the Federal Reserve Board will take next. With the next Federal Open Market Committee meeting less than two weeks away, investors and economists are awaiting some sign as to what the Fed is planning. It could go either way at this point, so all we can do it wait.

Federal Reserve Chairman Ben S. Bernanke gave a speech Monday evening on the effects of financial turmoil on the economy and policy.

“Overall, U.S. economic performance so far this year has been reasonably good. The rate of economic expansion slowed somewhat in late 2006 and early 2007, but growth in the second quarter was solid and some of that momentum appears to have carried over into the third quarter.”

We are currently doing well, according to Bernanke. We have had some recent troubles in which the Fed responded to promptly. Bernanke did mention that it is the job of the Federal Reserve to prevent financial crisis. He stated, “Indeed, a principal motivation for the founding of the Federal Reserve nearly a century ago was the expectation that it would reduce the incidence of financial crises by providing liquidity as needed.”

The chairman once again stood by the recent decisions of the Fed to cut rates. “The Federal Reserve’s efforts to provide liquidity appear to have been helpful on the whole…Fortunately, the financial system entered the episode of the past few months with strong capital positions and a robust infrastructure. The banking system is healthy.”

There are still challenges with inflation, and a great possibility of the housing market continuing the hold back some economic growth. “The decline in residential investment directly subtracted about 3/4 percentage point from the average pace of U.S. economic growth over the past year and a half.” Chairman Bernanke still remains positive about the overall economy. Things do not look good for the housing market, however. The chairman said, “The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year. However, it remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions.”

U.S. Treasury Secretary Henry M. Paulson, Jr., expressed similar concerns for families that will undergo strain due to the conditions of the housing market. Paulson plans to be more active in the mortgage lending sector, and watching things much more closely in the near future.
Market conditions slipped very slightly this week. Things will probably stabilize for now, however.

As for the Chairman, rate cuts do not seem a likely event in the next FOMC meeting. “For now, the Federal Reserve will continue to watch the situation closely and will act as needed to support efficient market functioning and to foster sustainable economic growth and price stability.” Unless there is a crisis over the next two weeks, the rates will probably remain as they are.