Janet Yellen's Speech to the NABE

Below is the prepared text from San Francisco Fed President Janet Yellen's speech to the National Association for Business Economics’ Annual Meeting in San Francisco, California:

Recent Financial Developments and the U.S. Economic Outlook

Good morning. It’s my pleasure to welcome you to this beautiful city. I'm delighted that NABE chose to have its national meeting here, and I'm especially pleased to have been invited to speak to you today.  As some of you may know, I occasionally use colorful language to describe the economy. Certainly, the events in financial markets over the past couple of months have generated their share of it.  But I believe these are times when there is particularly great value in speaking deliberately, keeping a cool head, conducting careful analyses, and closely monitoring emerging developments.  So those considerations will be reflected in the tenor of my remarks today.  I would like to discuss recent events in financial markets, consider their impact on the prospects for the U.S. economy, and offer my perspective on recent Fed policy actions, both in its role in promoting stability in financial markets and in its role in the conduct of the nation's monetary policy.  I want to emphasize at the outset that these remarks reflect my own personal views and not necessarily those of the Federal Open Market Committee.

Let me begin with the financial markets and review some of the recent developments I consider to be relevant in evaluating the prospects for the economy going forward.  Beginning in mid-July, global financial markets became highly volatile and increasingly averse to risk. In the U.S., perhaps the most dramatic illustration of the ensuing flight to safety was the decline in the three-month Treasury bill rate, which dipped by almost 2 percentage points between mid-July and August 20th. 

Dramatically wider yield spreads on credit default swaps, which provide insurance against default on the underlying securities, are further evidence of increased risk aversion in financial markets.  Indeed, wider spreads are evident for a host of underlying instruments, from mortgages to corporate bonds, with lower-rated instruments seeing especially big increases in spreads. At the same time, options-based implied volatilities on a range of assets, from equities to foreign exchange, increased markedly, reflecting heightened uncertainty about the future.  Since mid-August, Treasury bill rates have partially rebounded and credit default spreads have abated somewhat, but risk aversion remains notably high. This same turbulence has hit markets abroad, where risk spreads and implied volatilities are up, and there has been a significant flight to safety.

Of greater relevance to monetary policy are movements in the borrowing costs facing households and firms, since it is these interest rates that influence spending decisions and aggregate demand.  On the corporate side, prime borrowers have experienced little change in their borrowing costs because higher spreads have been offset by lower Treasury rates.  Issuers of low-grade corporate bonds with greater credit risk, in contrast, face sharply higher borrowing costs: spreads have widened so much that yields are up substantially since mid-July.

In the mortgage market, increased aversion to risk has been particularly apparent, with spreads above Treasuries increasing for mortgages of all types.  Borrowing rates for low-risk conforming mortgages have actually decreased somewhat.  But other mortgage rates have risen, including those available to some borrowers with high credit ratings.  In particular, rates on jumbo mortgages, both fixed- and adjustable-rate, have risen noticeably since mid-July.  Rates on home equity loans and lines of credit are also up, especially for those with high loan-to-value ratios.

Of course, subprime mortgages have become difficult to get at any rate.  And that reflects another sign of the increased caution of market participants, specifically, sharply restricted credit terms and availability.  In the mortgage market, lenders have tightened credit standards, making nonprime and jumbo mortgages available to fewer borrowers.  For example, mortgage lenders report raising FICO scores and lowering allowable loan-to-value ratios in many mortgage loan programs, and many subprime programs have been shut down altogether.

Moreover, some markets have become downright illiquid; in other words, the markets themselves are not functioning efficiently, or may not be functioning much at all.  This illiquidity has become an enormous problem for companies that specialize in originating mortgages and then bundling them to sell as securities.  The markets for selling these securities have all but dried up, except for the lowest-risk, “conforming” agency mortgages that can be sold to Freddie Mac and Fannie Mae.  And a market where many firms, including financial institutions, get short-term funding is illiquid as well, namely, the market for asset-backed commercial paper—short-term business loans that are secured by other assets, often mortgages.  With liquidity problems in the markets in which many mortgage companies both sell assets and borrow, these firms have faced serious challenges, and a few have gone out of business.

Depository institutions also face some illiquidity, specifically in the funding markets for maturities in the one- to six-month range.  Compounding their liquidity problems are concerns that mortgages and other assets that are normally securitized may come back onto their balance sheets and that customers may draw on unsecured credit lines. 

To assess how financial conditions relevant to aggregate demand have changed, we must consider not only credit markets but also the markets for equity and foreign exchange.  These markets have hardly been immune to recent financial turbulence, but the changes since mid-July, on balance, are less dramatic.  Broad equity indices are down, but not sharply.  And the dollar has changed little on a trade-weighted basis, as appreciations against the euro and pound—which may reflect safe-haven demands—have been offset by a big depreciation against the yen, probably reflecting a withdrawal from the so-called “carry trade” in which investors borrowed at low rates in Japan and lent at higher rates in the U.S.

As these financial events have unfolded, many explanations have emerged.  I have little doubt that scholars will study and debate the causes for some time to come.  So I will only offer some tentative thoughts on why all of this happened.

CONTINUED

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