In his first semiannual monetary policy report to both houses of Congress on the state of the economy and the Federal Reserve’s actions, Fed Chair Bernanke described on Tuesday the current situation of financial markets going forward — as critical. He, however, assured the committee that efficiency in the functionality of financial markets, as essential links in the transmission of monetary policy to the economy and a critical foundation for economic growth and stability, remains the Federal Reserve’s main priority. Mr. Bernanke also added that his agency and other government entities were taking all necessary steps to unclog credit markets and improve overall market liquidity and market functioning.
In his testimony the Fed Chair stated that the U.S. economy is currently undergoing a severe contraction that has resulted in a deteriorating job market, considerable losses of equity and housing wealth, and negative consumer sentiment and spending. Recognizing the substantial worsening of the economic outlook, Bernanke hinted at the possibility of the current recession getting even worse than recent forecasts. Citing projections by the Fed’s Open Market Committee in January, he now expects the unemployment rate to reach 8.5%-to 8.75% in the Q4 of FY2009 from current 7.6% levels. The country’s GDP is projected to decline 1/2 percent to 1-1/4 percent this year, these projections, he said, reflect an expected contraction in the first half of this year combined with an anticipated gradual resumption of growth in the second half. Faced with the significant economic deterioration Bernanke said the FOMC anticipates exceptionally low levels of the federal funds rate for some time.
On a positive note the Fed Chief pointed out that a degree of stability to some financial markets has been restored. In particular, strains in short-term funding markets, he said, have eased notably since the fall, and LIBOR rates have decreased sharply. Conditions in the commercial paper market also have improved. Corporate risk spreads have declined somewhat from extraordinarily high levels, and the sharp outflows from money market mutual funds seen in September have been replaced by modest inflows. Bernanke however, recognized the fact that despite these favorable developments, significant stresses persist in many markets. Notably, most securitization markets remain severely clogged, other than that for conforming mortgages, and some financial institutions remain under pressure.
Mr. Bernanke after emphasizing the importance of continuing to complement fiscal stimulus with strong government action to stabilize financial institutions and financial markets said: “if actions taken by the Administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability–and only if that is the case, in my view–there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery.”
Mr. Bernanke concluded his testimony by reiterating the Federal Reserve commitment in using all available tools to stimulate economic activity and to improve credit market functioning.
While no one doubts the Fed’s commitment to get the economy going again, we have to find ways and restore ‘confidence’ in the financial system, an element nearly non-existent at the moment. As long as the persistency of this aspect will continue to dominate, further deterioration, or at least stagnancy at best, is to be expected in the overall economic climate. As Walter Bagehot noted in his Lombard Street “The basis of a successful credit system is confidence.”