Federal Reserve & Interest Rates

Federal Reserve Board Governor Randall S. Kroszner delivered a speech, Friday, on risk management and the economic outlook.  He expressed his views on monetary policy making, and how risks and uncertainly about the economic outlook have an effect on it.

He stated, “First, monetary policy must be set on the basis of forecasts; and, second, because forecasts are subject to substantial uncertainty, policymakers must adopt aspects of risk management in their approach…given the long and variable lags between changes in interest rates and changes in economic activity, as well as lags in receiving data about economic activity, monetary policy must be forward looking.”

Over the passed two months, there has been much deliberation on monetary policy, and some changes were made.  Governor Kroszner seems extremely confident that the decisions that were made by him, together with the Federal Open Market Committee (FOMC), will help our economy through the “rough patch during next year.”  He does expect that growth over the next year will proceed at a slower pace than the third quarter.

Governor Kroszner made some other predictions about the economic outlook based on current economic performance and data.  According to him, the weakening of home sales and the demand for construction on new residence will most likely continue.  Conditions for subprime borrowers will probably get worse.  Kroszner expects the interest rates on adjustable-rate subprime mortgages to reset and the build-up of home equity to slow.  This will make it more difficult for homeowners to refinance.

Consumer spending will probably be limited and business capital spending plans might also be reduced.  Labor market conditions “are still relatively solid, and foreign demand for U.S. goods and services remains strong.”

As far as the future, perhaps in another year or so, Kroszner says, “As conditions in mortgage markets gradually normalize, home sales should pick up, and homebuilders are likely to make progress in reducing their inventory overhang.  With the drag from the housing sector waning, the growth of employment and income should pick up and support somewhat larger increases in consumer spending.  And as long as demand from domestic consumers and our export partners expands, increases in business investment would be expected to broadly keep pace with the rise in consumption.”

There are still factors of uncertainty, including the prices of oil and other commodities.  The Governor seems confident that the economy is on the verge of growth, although it will be slow-coming.  It seems that there won’t be any further rate cuts this year.  The implications of Kroszner’s speech are that the most recent changes will sustain the economy during the coming year.  This is the clearest picture of our level of economic stability that we have had for months.  Hopefully, his predictions are fairly accurate.

Governor Randall S. Kroszner speaks for the Federal Reserve Board on the matter. The Office of Thrift Supervision and the Federal Deposit Insurance Corporation (FDIC) have worked together with the Federal Reserve since 1999 researching and proposing policies for a replacement of Basel I.

It is because of the fact that Basel I has become outdated, that the need has risen to change the policy. Initially, when Basel I was implemented, in 1988, corporate loans, consumer credit, and residential mortgages were regulated quite generally. Over the passed 19 years, the economy has evolved, and the need for a more detailed policy regarding the varied risks involved in these types of credit emerged.

In a passed discussion on Basel II, Governor Kroszner pointed out the three main problems with Basel I. “(1) the same amount of regulatory capital is assessed against all unsecured corporate loans and bonds regardless of actual risk, (2) all unsecured consumer credit card exposures are treated equivalently, and (3) almost all first-lien residential mortgage exposures are deemed equally risky” He explained that this was creating “perverse incentives” for banks to take on higher risks than they would under different policy.

More recently, Basel II was taken through the final United States rule for implementation. The adapted Basel II will enhance the risk-sensitivity of monetary policy and create a system that more effectively assesses creditworthiness of borrowers. Kroszner believes that better risk management practices and tools “will contribute to a more resilient financial system as a whole.”

It is the responsibility of core banks to begin implementing what is now know as the “Three Pillars of Basel II.” The first pillar divides the bank’s risk assessment into three categories, which are credit risk, operational risk, and market risk. The second pillar includes a supervisory review of the main risk assessments of pillar one, and a more detailed look at other types of risk, such as liquidity risk, reputation risk, and legal risk. The third pillar requires an increased disclosure or all of their risk assessment practices, to ensure that risk management is dealt with properly.

The full implementation of Basel II is still underway, and it was important to note the milestone in the process that has been reached. A slow and partial implementation of the policy will continue, and the Federal Reserve will be monitoring it closely for any adjustments that may be needed.

Federal Reserve Board Chairman Ben S. Bernanke commented on the current United States economic outlook and the recent actions of the Federal Open Market Committee at the end of October in his testimony on November 8, 2007.

The Gross Domestic Product (GDP) grew at an average pace of nearly 4 percent during the second and third quarters.  While it is true that increases in energy prices might lead to a rise in overall inflation, core inflation has modestly improved.  Investor concerns about the credit quality of mortgages triggered some financial turmoil.  Uncertainty about developments in the housing market and a loss of confidence in credit ratings as a reliable risk assessment lead to a sharp decline in demand in this area.

Chairman Bernanke stated that “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. “

At the latest FOMC meeting, there was evident of strong growth in employment and income gains, and therefore consumer spending.  Despite this growth, the FOMC considered the mortgage lending issues, and the data that suggested that banks had tightened terms and standards regarding credit products.

Downside risks, including failing financial market conditions and large inventories of unsold homes were contributing factors in the recent federal funds rate reduction action.  Inflation continues to be a concern for the Fed, however, in order to “forestall some of the adverse effects on the broader economy,” they decided to make another cut in the rates.

Lending practices and constantly being monitored and evaluated.  The Federal Reserve and Congress and working with the Federal Housing Administration (FHA) and NeighborWorks America to help prevent delinquency.  The Conference of State Banking Supervisors (CSBS) are also involved in assisting subprime mortgage lenders and borrowers to get loan repaid.

Bernanke stated, “We are looking closely at practices such as prepayment penalties, failure to escrow for taxes and insurance, stated-income and low-documentation lending, and failure to give adequate consideration to a borrower’s ability to repay.  Using our authority under the Truth in Lending Act (TILA), we expect that we will soon propose rules to curtail abuses in mortgage advertising and to ensure that consumers receive mortgage disclosures at a time when the information is likely to be the most useful to them.”

Hopefully, this latest rate cut move and the efforts to heal the wounded subprime mortgage market will begin the long process of stabilizing the economy.  Perhaps in a year we will have a clearer picture of what our economic outlook actually is.