Federal Reserve

This month, the Federal Reserve published its triennial Survey of Consumer Finances, an invaluable resource in gauging America's saving habits and shifts in net worth (especially for low-income populations). Some of the highlights:

 Alan Greenspan, Federal Reserve Chairman from 1987-2006, admitted before the House Committee onGovernment Oversight and Reform that he made mistakes as Fed chairman. Greenspan said the "flaw" in the assumptions he had over four decades was that lending institutions themselves were best able to protect the interest of their shareholders. The testimony marked a dramatic shift from a previously defensive position regarding his terms as chairman.

Meanwhile, the major ratings agencies, Moody's and Standard and Poor's, are undergoing thorough investigation by Congress as internal conversations about ignoring risk to make profits are revealed.

Snapshot asks, should regulators be making assumptions about the ability of financial institutions to manage their own risk?

Central banks in three of the world's largest economies, the U.S., U.K., and the Eurozone, are set to decide this week whether to raise lending rates. All three economies are flirting with recession but central banks fear that lowering rates would stoke inflation. Most analysts expect the three banks will hold rates steady until further signals that inflation is cyclical. Second quarter growth in the U.S. was a sluggish 1.9%, despite the fiscal stimulus package. Meanwhile, June consumer prices rose at the fastest rate in 25 years.

Snapshot asks, in the second half of 2008, will growth or inflation dominate central banks' interest rate policy?

Associated Press -Fed Likely to Hold Rates Steady Amid Crosscurrents
Market Watch - Dollar Flat as Traders Eye Central Banks
Bloomberg - Rolling Recessions Bring Paralysis to Bernanke, King, Trichet

Regional banks are finding it difficult to raise enough capital to fend off fears over their poor financial health. A recent report from Goldman Sachs claims banks will need $65bn in addition to the $120bn they already raised to shore up their balance sheets. Most national and global banks continue to find investors, but regional banks are struggling to secure financing and investors are convinced they are too small to receive a government bailout. Last week, IndyMac's failure will likely cost the FDIC almost 8 billion dollars.

Snapshot asks, is the FDIC's $53bn fund adequate to handle a run on regional banks?

Promises by the U.S. Treasury and Federal Reserve to support Fannie Mae and Freddie Mac have not reassured shareholders. By noon Tuesday, shares of Fannie Mae dropped 23.5% and Freddie Mac plunged 24.9%. Given the loss of investor confidence in these mortgage finance companies, it appears that the promised equity investment by the Treasury may be utilized. In addition, Paulson proposed increasing Fannie and Freddie's $2.25bn credit lines to an undetermined amount to ensure "flexibility" and "minimize taxpayer risk."

Snapshot asks, what is the limit of taxpayer responsibility to maintain Fannie and Freddie's share price and help maintain financial stability?

Wall Street Journal - Bernanke, Paulson Aim for Stability with Fannie, Freddie Proposal
U.S. Treasury - Testimony by Secretary Henry M. Paulson, Jr.
Ben Bernanke - Semiannual Monetary Policy Report to the Congress

May payrolls fell 49,000 and the unemployment rate rose to 5.5 percent due to losses in the following cyclically sensitive sectors: construction, manufacturing, retail trade, and temporary help services. Healthcare continued to add jobs. It is the highest unemployment rate since October 2004 and the sharpest rise in unemployment in 22 years.

The most notable fact was the massive increase in household unemployment which rose 861,000 in the month of May, the largest increase in 33 years. This was due to new entrants to the labor force (recent high school and college graduates) as well as workers who lost their jobs.

Snapshot asks, since the Fed is typically very sensitive to unemployment, how will they balance May's unemployment data with inflation risks?

In his most recent speech, Ben Bernanke spoke about the dollar's weakness and its impact on producer and consumer price inflation. Bernanke has moved from focusing entirely on stability and growth to fighting inflation and the dollar decline. Folks such as Martin Feldstein recently said that the US didn't have a strong dollar policy, but it appears as though the Fed may have switched gears to fight inflation, and sees a strong dollar as a means to do so.

Snapshot asks, will the Fed's stance on the dollar continue to push the greenback higher?

Federal Reserve Vice Chairman Donald Kohn says conditions in the credit markets are improving. Equities prices have rallied, spreads on high-grade corporate bonds have fallen considerably, and firms have not had trouble raising funds in credit markets. These positive signs are the result of the Fed's efforts to boost liquidity, ability of financial institutions to raise capital, and better than expected economic data.

Despite some positive signs, credit conditions are not optimal. Many investors remain skeptical of credit quality and the securitization market of mortgages has fallen dramatically. Because the market for securitized loans has deteriorated, banks cannot bundle and sell loans and other assets. As credit conditions deteriorate and the risk of default increases, financial institutions have had to de-leverage their balance sheets.

Snapshot asks, are credit markets improving or have we only begun to see a drawn out process of de-leveraging?

Federal Reserve Bank of New York - May You Live in Interesting Times: The Sequel
Don Kohn - May 20th Speech
Financial Times - Fears of Prolonged Credit Crisis Hit Wall Street

Food and energy prices are rising and inputs for producers grow more expensive by the day, putting enormous pressure on central bankers to keep inflation low. This is pressure is particularly acute for Mervyn King and Jean Claude Trichet, the heads of the Bank of England and European Central Bank, who promise their governments to keep inflation around 2%. With no sign of a break in energy prices, the Bernanke Fed has also been warned by former Fed Chairman Paul Volker to keep inflation low. Volker said last week that there is a resemblance between today and the 1970s and that the Fed already introduced enough liquidity into the market.

Snapshot asks, are central bankers recklessly abandoning their inflation targets?

Martin Wolf - Britain Must not cut loose its anchor
Financial Times - Higher inflation stems from official neglect
Paul Volker - Act now to avoid inflation
Janet Yellen Federal Reserve Bank of San Francisco - Combination of Risks

Some are questioning whether the US is in a recession. Job losses last week were less than expected at -20,000. Many expected between -75,000 and -80,000. The stock market has rallied and the Dow Jones Industrial Average broke through the 13,000 mark last week. The Federal Reserve cut interest rates by 25bp but two members of the FOMC dissented. Richard Fisher, president of the Dallas Fed, and Charles Plosser, president of the Philadelphia Fed, argued there was no need for a cut. Despite a blip of positive news, the prospects for the U.S. housing market and American consumer are likely to continue to drag on the economy. For a graphic representation of how damaged the US housing market is, see Ben S. Bernanke's Mortgage Delinquencies and Foreclosures.

Snapshot asks, if this recession is led by falling housing prices and damaged consumers, when will it be worst?