Monday, July 7, 2008

Yellen, Repeat Yellen, Nails It

San Francisco Fed President Janet Yellen on Monday morning gave the best speech, on the current state of the economy, that any Fed member has given, in recent memory.

Does Yellen have a new advisor/speech writer?

Normally, a Yellen speech is a "on the one hand this, on the other hand that", type speech. Never saying much but never straying far from the mainstream Fed policy line.

The fog has obviously lifted on lower Market Street in San Francisco. Here's Yellen on the economy, clear and to the point.

Even a Macbeth reference to start things off. Cool:

To get a little fanciful with the stage-setting metaphor for a moment, it is a bit like the opening of Macbeth, with the three ghastly witches brewing up trouble amid thunder and lightning—only here, the three troublemakers are the housing market, the financial markets, and commodity prices.

But the overall economy is fine, says Yellen:

In the face of these adverse developments, the recent strength of spending data has been somewhat reassuring. The pace of consumer spending, in particular, has been surprisingly robust of late...The spending appeared to be broad-based, with the not-so-surprising exception of motor vehicles, where sales have been very weak in recent months. On the business side, orders and shipments of nondefense capital goods excluding aircraft also look to have rebounded somewhat in recent months. In addition, export growth has been a continuing bright spot. It has been buoyed by continued strong growth abroad and by the weakening of the dollar. The strong incoming data on spending ease my concerns somewhat about the intensity of the slowdown...

She knows there is an inflation problem:

Inflation has become an increasing concern. Over the past twelve months, the personal consumption expenditures—or PCE—price index rose 3.1 percent, up from 2.4 percent over the prior year. An important reason for these disappointing numbers, of course, is the rise in commodity prices. Some of those increases may have also passed through to core PCE price inflation, which excludes food and energy. This measure has averaged 2.1 percent over the past twelve months, which is slightly above the range that I consider consistent with price stability...

She remains negative on housing:

Unfortunately, it appears to me that there are at least three reasons for thinking that housing prices have further to fall. First, the ratio of house prices to rents—a kind of price-dividend ratio for housing—still remains quite high by historical standards, despite having fallen from its historical peak reached in early 2006. That suggests that further price declines may be needed to bring housing markets into balance. Second, inventories of unsold homes remain at elevated levels. This "excess supply" of available homes will put downward pressure on housing prices. Indeed, these inventories are likely to directly depress construction activity, since there is little point in building new homes when there is already a large backlog of unsold homes.... The bottom line is that construction spending and house prices seem likely to continue to fall well into 2009.

Yellen on the financial markets:

The ongoing fall in house prices has important implications for the financial markets, and it is one reason that we may continue to get troubling news from that part of the economy...Still market stress has subsided to some degree, and better quality borrowers are still able to get credit...But markets remain very fragile. For example, credit-default-swap spreads for many financial institutions are again on the rise, the debt ratings for several important bond insurers have been cut, and stock prices for financial institutions have plummeted.

There is further evidence that financial markets are still not operating efficiently or effectively. In particular, the market for private-label securitized mortgages of even the highest quality remains moribund.These securities were the primary source of financing for nonconforming residential mortgages, including subprime lending...Unfortunately, progress toward sturdier and more efficient financial markets is going to take some time, and that means the flow of credit is likely to remain impeded

She gets the nature of the securitization that caused the credit problems:

First, securitization was a key driver of the credit expansion. Financial institutions originated loans that they then bundled into securities and sold to other investors. With hindsight, it is clear that this originate-to-distribute model suffered severe incentive problems—the originator had insufficient incentive to ensure the quality of the loans, since someone else ultimately held them.

She again points out the inflation problems in the economy:

As if housing and a credit crunch weren't enough, prices for food and energy have gone through the roof. The spot price of West Texas intermediate crude oil has surged over 40 percent since January and over 100 percent in the last year, rising above $140 per barrel in late June. Prices for other commodities, such as many metals and foods, have risen sharply as well. Corn and wheat prices are up some 50 to 80 percent from a year ago.

And, makes some very astute observations on why speculators are not the problem:

There has been much discussion about speculative trading in commodities markets and its possible influence on recent price movements. Hedge funds, institutional investors, and other traders have certainly increased their positions in commodity markets, typically by investing in commodity index funds, which consist of baskets of different commodities that trade on exchanges. But I am not yet persuaded that speculation, rather than the fundamentals of global supply and demand, has played an important role in driving up prices. For example, it should be harder to speculate and take positions on commodities that are not easy to trade on futures markets and are not included in index funds. But the prices of individual commodities that are not in index funds have risen just as fast as those that are.

In addition, if speculators were important in driving prices up, then, at the high prices now prevailing, demand by nonspeculative end users would fall short of current supply, causing inventories to rise. In fact, however, inventories appear to have been declining in most commodity markets.

In short, an overall excellent recap of the current state of the economy. She, of course, dismisses, and sometimes excludes, the Fed's involvement in causing the financial and housing crisis and the inflation, but we will take what we can get.

Even if she also is a bit blind to the future severe inflationary problems that we see.

It is, thus, most appropriate that from the very Macbeth she quotes, in the closing stanza of Act I, Scene I of Macbeth, the three witches warn in unison:

Fair is foul, and foul is fair:
Hover through the fog and filthy air

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