Are Bernanke’s Hands Tied? 8 Reasons the US May Be in Worse Trouble Than You Think

News and information on the rapidly unfolding economic crisis is pouring forth on a daily basis. "Prominent investment bank announces $10 Billion write-down and records first quarterly loss in years; Stocks tumble as fallout from housing crisis spreads; Rating agencies criticized for role in credit crunch" represent a small cross-section of headlines. Unfortunately, most of the reporting speaks to the crisis itself and its ultimate causes, rather than to what the near future holds and to what can be done to prevent a complete collapse.

Too much ink has been spilled trying to understand whether the crisis was inevitable and by extension, whether more or less financial regulation would have produced a different outcome. Perhaps, there exist more important questions, such as "What can be done now?" and "Is recession inevitable?"

This paper aims to explore- if not answer- these questions, through the prism of US monetary policy. In short, what can the Federal Reserve Bank do to forestall economic recession, or is it already too late?

  1. Housing Bubble: From 2001 to 2005, millions of mortgages were extended to unqualified borrowers, enabling a record run-up in housing prices. As the Fed raised interest rates to cool the economy, many of these homeowners suddenly found themselves unable to make payments on their mortgages, especially those of the adjustable rate variety. Since the inception of the credit crunch, a sudden aversion to risk and the foreclosure on millions of properties has led to a tremendous supply/demand imbalance in the housing market. As a result, prices have certainly stopped rising and even started falling in certain regional markets. The National Association of Realtors recently announced that 2007 saw the largest drop in existing home sales in 25 years, and "the first price decline in many, many years and possibly going back to the Great Depression." All of this data presents an economic problem of catastrophic proportions because most of the average American family’s equity is tied up in its home. During the boom, many families refinanced or borrowed using home equity loans, which was used to fuel corresponding booms in spending and in the stock market. The situation has since reversed itself. According to Merrill Lynch, "Nearly 9 million households now have upside-down mortgages, and for the first time ever, aggregate mortgage debt is bigger than the total value of homeowner equity by $836 billion." In short, says US Treasury Secretary Henry Paulson, the "housing decline is the most significant risk to our economy."
  2. Wall Street: On a related note, the second area of economic concern is Wall Street, which both packaged the mortgage securities in question and invested heavily in them. In February 2007, HSBC became the first investment bank to acknowledge losses ($10.5 Billion) on subprime investments, kicking off the credit crunch. Since then, virtually every financial institution- with the notable exception of Goldman Sachs- has announced massive write-downs on subprime investments. Estimates are hard to come by, but at least $160 Billion in losses have already been accounted for. How much worthless debt remains on the books is anyone’s guess. The low estimate, $285 Billion, was offered by S&P (rating agency) and the high estimate of $600 Billion is claimed by UBS (investment bank), which recently wrote down $20 Billion of its own investments. These write-downs are driven by a widespread default rate on subprime mortgages, estimated by one analyst at 30-40%. As a result of the defaults, several prominent hedge funds have collapsed, scattering debris to the four corners of the financial universe. Of more significance is the breakdown of financial institutions, themselves. Bear Stearns, an investment bank, collapsed suddenly and spectacularly, such that the Federal Reserve Bank of New York had to cobble together an 11th hour sale of the firm to JP Morgan in order for Bear to avoid declaring bankruptcy and risk destabilizing the entire financial system. Then there are the companies that insure the mortgage securities, and the lending institutions that originated them, which are also in trouble. Finally, the quasi-governmental organizations FANNIE MAE and FREDDIE MAC, which provide the system with liquidity by acting as buyers of last resort for mortgages, have capped their exposure due to mounting losses. In short, any assessment of the likelihood of recession must first estimate the risk of further unanticipated subprime write-downs and consequent bankruptcies in the financial sector.
  3. Inflation: Shifting gears for a moment, the second item of concern is inflation. While not technically germane to the discussion of economic weakness, inflation is important because it limits the Fed’s ability to loosen its monetary policy. While the Fed’s mandate is not specifically to facilitate price stability (as compared to most Central Banks), it is still an important factor in its monetary policy. The current situation is unique because inflation is rising while economic growth is falling, threatening to return the US to the "stagflation" of the 1970s. The prices of commodities have risen dramatically over the last year. Gold and oil recently breached the psychologically important thresholds of $1000/ounce and $100/barrel, respectively, though they have since retreated. Prices of certain food staples, such as rice and corn, have doubled, due to surging demand in emerging markets and shortages caused by a shifting of farmland to the production of biofuels. In addition, the value of the USD has eroded the purchasing power of US consumers. [The Dollar has fallen by 70% against the Euro over the last five years]. The US is on pace to import nearly $2.5 Trillion worth of goods and services in 2008, which means every 1% in currency depreciation costs the US $25 Billion! As a result, the US consumer price index (CPI) is growing at an annualized clip of 4%, well above the stated comfort zone of 2%. This could inhibit the Fed from cutting rates further.
  4. No Confidence: Connected to inflation is the loss of confidence among consumers. According to Merrill Lynch, "By the end of 2007, 36 percent of consumers’ disposable income went to food, energy and medical care, a bigger chunk than at any time since records were first kept in 1960." The same article also noted that more families are eating meals at home, a sign that discretionary spending is being curtailed. Consumption represents the backbone of the US economy. Thus, it bodes ill that consumer confidence is at its lowest level since the early 90’s, having dipped below the trough it reached during the 2001 recession. Even Starbucks has admitted feeling nervous; during a recent press conference, it suggested that the ailing consumer could interfere with its corporate restructuring plan. In addition, unemployment is slowly creeping up, recently breaching the 5% mark for the first time in two years. Since unemployment is a lagging economic indicator, it won’t peak until one to two years after the height of the economic downturn. It should be noted that financial institutions are leading the way in job cuts, by trimming their own staff.
  5. Credit Spreads: Credit Spreads refer to the cost of capital, for both debt and equity, which lenders and shareholders receive in compensation for risk. The spread is basically a percentage tacked onto the risk-free rate (yield on US Treasury Securities). One of the main symptoms of the credit crunch is widening credit spreads, in which investors demand higher interest rates to compensate them for higher perceived risks. As a result, many bond and equity issues have been delayed, as companies wait for more favorable conditions to emerge. In addition, hedge funds and private equity funds are finding it increasingly difficult to raise funds to support their activities, which is negatively impacting stock market valuations. From an economic perspective, credit spreads are problematic because companies are either unable or unwilling to secure the capital required for massive projects and consequently from hiring workers to develop and staff those projects. Underlying the widening of credit spreads is a collapse in trust. An unnaturally large percentage of securities that were rated AAA (very unlikely to default) and that were recommended by investment banks, now run the risk of default, which makes investors reluctant to lend and invest further. In fact, "global first-quarter underwriting volume tumbled 45% from a year earlier to $1.27 trillion, and fees collected by Wall Street investment banks fell 47% to $5.8 billion," according to the Wall Street Journal. From the standpoint of the Fed, widening credit spreads are problematic because even if it cuts rates, investors may still demand the same return, and net liquidity won’t change.
  6. Sagging Stock Market: Since peaking in early October, all of the major US stock market indices have declined. The S&P 500, the broadest measure of US stock market performance, is down 16%. In fact, the first quarter of 2008 marked the worst start of a year ever for US equities. That’s EVER. These numbers are significant because the stock market is considered a reliable leading indicator for the economy. Thus, the collapse in stock market prices-which may not yet have bottomed out- signify that investors are bearish on the economy’s near-term prospects for recovery. In addition, the downward trend in stocks has been accompanied by a surge in volatility. According to the Wall Street Journal, "the S&P 500 moved more than 1% on 51% of the trading days in the first quarter, the biggest percentage since 1934 and the fifth-largest percentage in the index’s history." Moreover, the Fed’s interest rate cuts, which were intended to create liquidity in the various financial markets, failed to lift stocks and reinforced the notion that the wounds inflicted by the credit crunch are too deep to be healed by monetary policy alone.
  7. Monetary Policy: The Fed, itself, represents the next reason why it may be too late for the Fed to act to prevent recession. Interest rates have already been cut by a total of 300 basis points, capped by a massive 75 basis point cut on March 18. As a result, the benchmark Federal Funds Rate now stands at 2.25%, which is actually negative when adjusted for inflation. Speaking of inflation, the Fed will likely hesitate to lower rates further because doing so would come at the expense of price stability. Furthermore, monetary policy is not the only area where the Fed has been active; it has also announced that it will set aside up to $400 Billion for lending to financial institutions and banks. The Fed will offer both short-term loans and longer-term loans collateralized by illiquid mortgage-backed securities in an effort to increase lending activity. "The Federal Reserve…is trying to ease an acute credit squeeze by agreeing to hold large volumes of mortgage-backed bonds that Wall Street firms are struggling to sell and providing them with…cash." Finally, the Fed will take on a larger regulatory and oversight role of the financial sector. The unregulated origination and subsequent repackaging and collateralizing of mortgages is considered one of the prime causes of the current crisis. In short, the Fed may have hamstrung itself by acting too quickly and exhausting the tools in its arsenal.
  8. Fiscal Policy: When monetary policy isn’t enough, the next best alternative is fiscal policy. Unfortunately for the Fed, Washington lawmakers have already acted, unveiling a $150 Billion economic stimulus package. The plan is supposed to ignite the economy through tax cuts to individuals, families and small businesses. President Bush has personally insisted that the stimulus plan is all that is needed to return the economy to solid footing, but the government’s track record suggests that the outcome is far from certain. Taxpayers behaving rationally would save, rather than spend their tax rebates, in anticipation of future, offsetting tax increases. Either way, it will be three to six months before economists can begin to measure the effects of the tax rebates.

Based on the grim situation outlined above, it appears the Fed’s hands ARE tied. All of the leading indicators, namely those which measure confidence and stock market performance, suggest that the prospects for averting recession are bleak. In addition, both the Federal Reserve Bank and the Federal Government have already unveiled massive initiatives to prime the pump of the economy and stimulate lending and consumption, respectively. The Fed is constrained from lowering rates further because of inflation, and the government is loath to spend more because of the fiscal deficit. Thus, both entities may be relegated to the sidelines for the duration of the crisis, watching with baited breath to see if their actions were sufficient to prevent a complete economic collapse.