San Francisco Federal Reserve President Janet Yellen spoke Tuesday, discussing the series of events which led to the credit crunch, which she labeled "one of the most significant economic shocks in our memories—one that is seriously affecting the U.S. outlook." Speaking at the Certified Financial Analysts Institute in Canada, Yellen added that she expects the economy will "improve somewhat" in the second half of 2008, although that forecast comes with some "unusually large" risks including financial turmoil, the housing crisis, and soaring commodity prices.
Yellen was critical of the performance of financial supervisors and regulators, including the Federal Reserve, as the crisis developed.
"Financial supervisors and regulators, including the Federal Reserve, were behind the curve," Yellen said in prepared remarks. "We missed some of the risky developments that were unfolding."
Specifically, she cited "insufficient" consumer regulations which allowed some of the unfair lending practices to take place. Additionally, Yellen said that policymakers "took too long" to institute and strengthen supervisory policies as the housing bubble expanded.
"On a broader level, the situation exposed holes in the existing regulatory framework for financial services, which allowed some risky activities to flourish, hurting both consumers and financial stability," the San Francisco Fed President said. "Significantly, the Fed was compelled to open the discount window to investment banks because of the outsized risks some took and their significant interconnectedness with the financial market infrastructure. Investment banks thus were able to operate with less capital and supervision than such access otherwise entails. "
Yellen detailed a series of "liquidity-enhancing actions" taken by the Federal Reserve to mitigate the effects of the financial crisis, including reducing the federal funds rate, taking a prominent role in the Bear Stearns rescue, and working with central banks around the world to facilitate lending.
"I believe that the Fed's liquidity operations, combined with its 325-basis-point cut in the Federal funds rate—a substantial easing of monetary policy—are having a beneficial effect on financial markets," Yellen said. "Although overall financial conditions are still far from normal, there are some rays of hope that the strains may be easing a bit."
Specifically, she cited an easing of spreads in the market for GSE-sponsored mortgages, along with a substantial decrease in credit default swap spreads on many financial institutions.
Yellen's outlook for the housing market is considerably less optimistic, and she predicted that "construction spending and house prices seem likely to continue to decline well into 2009."
Turbulent financial markets, a slumping housing market, and soaring commodity prices have combined into what Yellen labeled a "grim trio" that weighs on demand by private and commercial sectors. Although there are some good signs, such as GDP that remains positive, Yellen offered a mixed forecast for the coming year.
"Starting in the fourth quarter, the economy slowed to a crawl," the San Francisco Fed President noted. "With stimulus from monetary and fiscal policy, economic performance may improve later this year."
However, while performance may improve slightly, she predicts that "the economy is still likely to turn in a very sluggish performance for the year as a whole."
"I want to emphasize that we are facing an unusually high degree of uncertainty at the present time," Yellen said.
The San Francisco Fed President called recent data on inflation "disappointing," noting that some believe stagflation remains a threat.
"Even if the direct influences of commodity prices on inflation eventually dissipate, they could still cause trouble," Yellen said. "Some fear that the specter of stagflation may rear its ugly head as it did in the 1970s and early 1980s."
However, Yellen does not believe we are about to enter a period of stagflation, rather forecasting that "over the next couple of years…total and core inflation will moderate from present levels."
As far as monetary policy, Yellen appeared to be leaning away from future rate cuts, stating that "Under these circumstances, I consider the current level of monetary accommodation to be appropriate."
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