Federal Reserve & Interest Rates

In a speech before the Economic Club of New York, Fed Chairman Ben Bernanke see continued growth for the economy into next year.  He admits though that growth is likely to be slow due to a number of factors.

My own view is that the recent pickup reflects more than purely temporary factors and that continued growth next year is likely. However, some important headwinds–in particular, constrained bank lending and a weak job market–likely will prevent the expansion from being as robust as we would hope. I’ll discuss each of these problem areas in a bit more detail and then end with some further comments on the outlook for the economy and for policy.

Many economists believe we could be entering a jobless recovery phase, as it could be quite some time before the job market begins to recover.  Some believe the unemployment rate could reach as high as 13% before job creation starts again.

With inflation concerns still minimal at this time, he states that low interest rates will likely be warranted for some time and while some critics have called for higher interest rates, it could be as much as a year or more before we see any significant rise in the federal funds rate.

With banks expecting more loan losses from a weak housing market, a number of institutions have been hoarding cash, which has constrained bank lending to a degree.  Weak consumer spending has also caused credit demand to be well below normal levels, although those who are seeking credit are finding a difficult time of it.

While the banking system hasn’t fully recovered, it has stabilized somewhat and now that banks have sufficient capital reserves, the Fed has begun to ramp down it’s liquidity programs.  Although it’s balance sheet activity has slowed of late, it would not be surprising if we were to see the Fed use this tool once again next year if inflation concerns remain muted.

The Federal Reserve issued a press release on Monday concerning the Supervisory Capital Assessment Program(SCAP).  Since the start of the financial crisis last fall, financial institutions have frantically raised their capital levels and are even now continuing to de-leverage their positions.

The Federal Reserve Board on Monday said that 9 of the 10 Bank Holding Companies (BHCs) that were determined in the Supervisory Capital Assessment Program (SCAP) earlier this year to need to raise capital or improve the quality of their capital to withstand a worse-than-expected economic scenario now have increased their capital sufficiently to meet or exceed their required capital buffers.

The one exception, GMAC, is expected to meet its remaining buffer need by accessing the TARP Automotive Industry Financing Program, and is in discussions with the U.S. Treasury on the structure of its investment.

Some economists believe the banking system may have too much liquidity at the moment.  While they are well positioned in case of a worst case scenario, the lack of credit being supplied to the market is worrisome.

Much of this may also have to do with the historically low interest rates the Fed currently has set.  Everyone knows the Fed will probably raise rates starting sometime next year and when that happens, consumer rates will rise as well.

Banks might be reluctant to start heavy lending at current interest rates when they aren’t likely to last and being locked into long term loans at low rates would be especially problematic with the lack of a secondary market to rollover those loans.  On the flip side, many Americans are also conscious of the weak labor market and have increased their savings rate over the past year, so the demand for credit is somewhat lacking as well, even with the currently low interest rates.

So even though the banking system has stabilized somewhat, the supply and demand for credit is still well below normal levels and it could remain that way for some time.

The Federal Open Market Committee met this week and to no ones surprise left interest unchanged once again and issued a press release following their meeting.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

There have been call from some circles to raise interest rates recently, most notably from former Fed Chairman Alan Greenspan.  While GDP grew once again in the last quarter, signaling the end of the recession, numerous problems still lie ahead for the economy.

The banking system is still in a fragile state, with many financial institutions hoarding cash, still reluctant to lend to consumers whose demand for credit is also well below normal levels.  The housing market, while it has had increased activity as of late, has yet to recover and that could still be years away.

Consumer spending is also way down and many household have increased their savings rate, with an uncertain labor market for the foreseeable future.  The economy is just at the start of the recovery phase but much of the positive GDP growth from last quarter was mostly due to the fact of the increased fiscal spending the government has undertaken over the past year.

It may be as much a year, if not longer before the Fed raises interest rates once again or begins shrinking it’s balance sheet for that matter.  While the Fed has to be careful about timing it’s exist strategy, with the current state of the economy, monetary easing doesn’t appear warranted just yet.