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Monetary Policy and Financial Stability Eric S. Rosengren President & CEO Federal Reserve Bank of Boston The Business and Industry Association of New Hampshire and the New Hampshire Bankers Association Manchester, New Hampshire March 27, 2013 EMBARGOED UNTIL WEDNESDAY, MARCH 27, 2013 AT 12:30 P.M. EASTERN TIME, OR UPON DELIVERY www.bostonfed.org Economy Improving Slowly Despite headwinds – problems in Europe and more fiscal austerity in the U.S. than many expected – the economy is slowly improving Large-scale asset purchases (LSAPs) have helped interest-sensitive sectors and are helping to offset fiscal headwinds With unemployment at 7.7 percent and PCE inflation at 1.2 percent, the economy remains far from where we want it to be 2 Preview Despite benefits of LSAPs, how large are the costs? Inflation remains low, and that is expected to continue Financial stability – need to monitor closely, but seeing little evidence that monetary policy is causing significant financial stability problems at this time In short, benefits currently outweigh costs 3 Figure 1 Growth in Real GDP Components 2011 and 2012 Percent Change from Year Earlier 20 2011:Q4 2012:Q4 15 10 5 0 -5 Residential Investment Source: BEA / Haver Analytics Consumer Durable Goods Federal Government Spending State and Local Government Spending 4 Figure 2 Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents September 2012 and March 2013 8.5 Unemployment Rate Range Fourth Quarter 2.5 PCE Inflation Range Fourth Quarter - Fourth Quarter 2.2 8.0 2.0 8.0 2.1 2.1 2.0 1.9 1.8 7.5 7.6 7.5 1.75 1.65 1.5 7.5 1.6 1.5 1.4 1.3 7.25 7.0 7.1 7.0 6.9 1.0 6.9 6.6 6.5 0.5 6.3 6.1 6.0 Sep 2012 Mar 2013 Mar 2013 Sep 2012 Projections for Projections for Projections for Projections for 2013 2013 2014 2014 Source: Federal Reserve Board 0.0 Sep 2012 Mar 2013 Sep 2012 Mar 2013 Projections for Projections for Projections for Projections for 2013 2013 2014 2014 5 Benefits of LSAPs Help reduce longer-term rates – promote economic growth and more quickly return to full employment with stable prices FRB Boston uses two models – one structural, one statistical Both imply roughly $500 billion in asset purchases result in one-quarter point reduction in unemployment – almost 400,000 jobs Estimate is model dependent, subject to estimation error 6 Potential Cost: Inflation Potential that inflation or inflation expectations could rise too quickly Federal Reserve balance sheet expanded significantly in 2008, and almost five years later, PCE inflation is 1.2 percent – well below 2 percent target This provides the Fed the ability to take monetary policy actions to encourage stronger growth 7 Potential Costs: Financial Instability Potential that interest rates at zero lower bound may induce investors to take on excessive risk Too much credit risk Too much interest rate risk Intent of policy, in part, is to encourage households and firms to not be excessively risk averse – i.e., to encourage responsible risk-taking that advances real economic activity and growth 8 Figure 3 S&P 500 Composite Stock Price Index January 1993 - February 2013 Index 2,000 1 1,600 1 1,200 1 800 0 400 0 0 0 Jan-1993 Jan-1997 Jan-2001 Jan-2005 Jan-2009 Jan-2013 Recession Source: S&P, NBER / Haver Analytics 9 Figure 4 S&P 500 Composite Price/Operating Earnings Ratio January 1993 - February 2013 Ratio 1 40 1 30 20-Year Average 1 20 0 10 0 0 0 Jan-1993 Jan-1997 Jan-2001 Jan-2005 Jan-2009 Jan-2013 Recession Source: S&P, NBER / Haver Analytics 10 Figure 5 U.S. Regional Home Prices: S&P/Case-Shiller Metro Area Indexes March 2006 - January 2013 Index Level March 2006 = 100 110 100 110 Boston 100 110 Chicago 100 110 Denver 100 110 New York 90 90 90 90 90 80 80 80 80 80 70 70 70 70 70 60 60 60 60 60 50 50 50 50 50 40 40 40 40 40 30 Mar-06 30 Mar-06 30 Mar-06 30 Mar-06 Aug-09 Jan-13 110 100 Aug-09 Jan-13 110 Los Angeles 100 Aug-09 Jan-13 110 Miami 100 Aug-09 Jan-13 110 Phoenix 100 30 Mar-06 100 90 90 90 90 80 80 80 80 80 70 70 70 70 70 60 60 60 60 60 50 50 50 50 50 40 40 40 40 40 Aug-09 Jan-13 30 Mar-06 Aug-09 Jan-13 30 Mar-06 Source: S&P/Case-Shiller / Haver Analytics Aug-09 Jan-13 30 Mar-06 Aug-09 Jan-13 110 San Diego 90 30 Mar-06 Las Vegas 100 Aug-09 Jan-13 San Francisco 30 Mar-06 Aug-09 Jan-13 11 Figure 6 Price-to-Rent Ratio 1993:Q1 - 2012:Q4 Index Level 1993:Q1=100 180 160 Ratio of S&P/Case-Shiller Home Price Index to Consumer Price Index for Rent of Primary Residence 140 120 100 80 60 1993:Q1 1996:Q1 1999:Q1 2002:Q1 Source: S&P/Case-Shiller, BLS / Haver Analytics 2005:Q1 2008:Q1 2011:Q1 12 Figure 7 High-Yield Bonds: S&P 10-Year BB+ Industrials Bond Yield March 1996 - February 2013 Percent 14 12 10 8 6 4 2 0 Mar-1996 Mar-2000 Source: S&P / Haver Analytics Mar-2004 Mar-2008 Mar-2012 13 Figure 8 High-Yield Bond Spread: S&P 10-Year BB+ Industrials Bond Yield to 10-Year U.S. Treasury Yield March 1996 - February 2013 Percent 12 10 8 6 Average over Period 4 2 0 Mar-1996 Mar-2000 Mar-2004 Source: S&P, Federal Reserve Board / Haver Analytics Mar-2008 Mar-2012 14 Figure 9 Rates on Mortgage Loans, Auto Loans, and High-Yield Bonds January 2011 - February 2013 Percent Percent Percent 5.5 6.0 8.0 Rate on 30-Year Fixed-Rate Mortgage Rate on 48-Month New Car Loan 5.0 5.0 7.0 4.0 6.0 3.0 5.0 4.5 4.0 3.5 Rate on S&P 10-Year BB+ U.S. Industrials Bonds 3.0 Jan-11 Jan-12 Jan-13 2.0 Jan-11 Source: FHLMC, WSJ, S&P / Haver Analytics Jan-12 Jan-13 4.0 Jan-11 Jan-12 Jan-13 15 Figure 10 Tier 1 Common Capital Ratio for Large U.S. Banking Organizations 2007:Q1 - 2012:Q4 Percent 12 10 8 6 4 Tier 1 Common Capital to Risk-Weighted Assets 2 0 2007:Q1 2008:Q1 2009:Q1 2010:Q1 2011:Q1 2012:Q1 Note: Includes 14 large banking organizations that filed the FR Y-9C throughout the six-year period Source: Consolidated Financial Statements for Bank Holding Companies (FR Y-9C) 16 Figure 11 Agriculture-Related Loans as a Share of Assets at Commercial and Savings Banks by Asset Size December 31, 2012 Percent 8 6 4 2 0 Less than $500 $500 Million to Million $1 Billion $1 Billion to $10 Billion $10 Billion to $100 Billion to Greater than $1 $100 Billion $1 Trillion Trillion All Banks Bank Asset Size as of December 31, 2012 Note: Includes agricultural production loans and real estate loans secured by farmland Source: Commercial and Savings Bank Quarterly Call Reports 17 Risks Seem Manageable Broad-based financial stability concerns do not seem acute at this time Falling interest rates and rising asset prices are expected results of the policy With improvement in economic outlook, accommodation can be withdrawn Nonetheless, financial stability concerns need to be monitored 18 Areas to Monitor Closely Underwriting standards – decline in covenant quality for leveraged loans and high-yield bonds Short-term borrowing to finance long-term assets – e.g., agency REITS Run risks exposed in financial crisis and not yet resolved – e.g., MMMFs, reliance on wholesale funding, broker-dealers 19 Concluding Observations The economy continues to improve, but at a painfully slow pace Benefits of Fed policy actions are clear from improvement in interest-sensitive sectors Need to monitor for potential financial stability problems – but at this time the benefits of our programs outweigh the costs 20