Federal Reserve & Interest Rates

During an economic conference at the Federal Reserve Bank of Boston, Chairman Bernanke called for legislative action from Congress to close regulatory gaps,  as well as give regulators the power to unwind failing non-banking firms.  Only the FDIC currently holds such power over financial institutions with bank holding companies.

Supervisors in the United States and abroad are now actively reviewing prudential standards and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher-quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers.

On the supervisory front, we are taking steps to strengthen oversight and enforcement, particularly at the firmwide level, and we are augmenting our traditional microprudential, or firm-specific, methods of oversight with a more macroprudential, or systemwide, approach that should help us better anticipate and mitigate broader threats to financial stability.

States which regulates insurance companies and the SEC which had regulated the now defunct investment banking sector had little such power, which led to little choice last year but to let Lehman Brothers collapse and AIG receiving a massive federal bailout.  While both Citigroup and Bank of America also required substantial federal aid subsequently, much of that was due to the global liquidity crisis which ensued following the problems of the two above mentioned institutions.

While Congress has been expected to act for some time and many changes are expected in the financial regulatory structure, little has been done thus far with it’s main focus on healthcare reform at the moment.  A plan which has gained steam recently is the creation of a regulatory council made up from a number of federal agencies with the power to supervise firms deemed systemic risks to the greater economy.

There have also been many calls to break up so called firms that are “too big” to fail in order to avoid a repeat of last year where substantial taxpayer dollars were put at risk in order to rescue the economy from financial collapse.

The Federal Reserve has kept interest rates at nearly 0% for some time now and by all accounts it will remain at that level through next year.  Now over a year removed from the beginning of the financial panic, credit markets have yet to recover.

Consumers and businesses are reluctant to borrow and financial institutions are reluctant to lend, even with interest rate at historical lows.  Consumer spending has been stagnant and with demand still low, businesses are loathe to make capital investments.

Throughout the recession, the savings rate of American households continues to climb despite repeated efforts by the government to stimulate consumer spending through stimulus payments and incentive programs.  Although the economy is expected to return to positive growth this quarter, it’s been mainly driven though the government’s fiscal and monetary policy initiatives.

With it’s normal monetary policy tool exhausted, the Federal Reserve has had to use balance sheet growth to expand the money supply.  The federal government has also had to undertake massive budget deficits in order to rescue the financial system.

With the current state of the credit system, talks of exit strategies might be premature at this juncture.  Short term inflation expectations remains low but it is something the government will have to worry about in the long run.

Financial institutions are still trying to de-leverage themselves and hundreds of banks are likely to fail in the next three to four years.  Consumer confidence will also likely remain muted for some time with the labor market expected to take years to recover.

Despite the record growth of the national debt, a number of individuals have cautioned against the government reducing it’s fiscal spending anytime soon or the economy could see a series of fits and starts as it tries to recover.

Federal Reserve Chairman Ben Bernanke gave an overview on Monday, on the impact of the financial crisis on Asia’s largest economies and it’s policy responses.  The growth in global trade allowed the financial crisis which began it this country to transmit it’s effects to the rest of the world, and Asian economies were hit hard but aggressive policy actions by many of those countries appears to have paid off.

In September and October 2008, as you know, the global financial crisis intensified dramatically.  Concerted international action prevented a global financial meltdown, but the effects of the crisis on asset prices, credit availability, and consumer and business confidence resulted in sharp declines in demand and production worldwide.  Reflecting this worsening economic climate, Asian GDP growth slowed further in the second half of 2008. 

For the region as a whole, the economic contraction in the fourth quarter of 2008 was pronounced, with activity falling at an annual rate of nearly 7 percent.  The fourth-quarter declines were especially dramatic in Taiwan and Thailand (more than 20 percent at an annual rate) and in South Korea and Singapore (more than 15 percent at an annual rate).  Among the major Asian economies, only those of China, India, and Indonesia did not contract during the crisis.

For most Asian countries, the severe drop off in global trade as well as disruptions in international capital flows played a large factor in the recessions of those countries.  However, low inflation levels allowed most of those countries to take aggressive stimulus actions and their economies appear to be on the brink of recovery.

Large trade and capital flow imbalances helped transmit financial instability to their economies and Bernanke points out that efforts need to be taken in the future to prevent this.  The United States need to increase it’s national savings rate but the large federal deficits expected over the next decade may make this difficult, on the flip side, Asian countries could reduce their overall savings rate by promoting domestic consumption, which may also prove difficult.

The lessons learned from the financial crisis has proved that global economies must take cooperative fiscal and monetary policy measures which are mutually beneficial.